Brush up on bonds, boomers

Posted: November 20, 2011

Baby boomers fully embraced the stock market by riding its ups and downs throughout their peak income years.

But now that the oldest boomers are turning 65, their focus has turned toward ensuring a steady income from their investments. And they're likely to find the answer is to put money in bonds rather than stocks, as recent market volatility shows.

Broadly diversified bond mutual funds have provided investors an average annualized return of nearly 5.6 percent over the last five years. That is better than all the domestic stock-fund categories Morningstar tracks.

With retirement nearing for such a sizable population, it's understandable that investors have deposited a net $670 billion into bond mutual funds since January 2009 while consistently pulling money out of stock funds. Fidelity Investments says its clients alone have added $100 billion in new cash to bond investments over the last three years.

But do stock-savvy boomers and others who have flocked to fixed-income investments really understand bond investing and the potential risks and rewards?

Many fund companies say there is a pressing need for investors to bone up on their bond basics. Fidelity upgraded online resources for bond investors in September; Nuveen Investments made a similar move this month. It is a recognition that bonds are more complex than stocks, with more moving parts that influence investment returns - yield, price, and interest rates, for starters.

Interest rates are perhaps the most critical risk for bond investors now. Short-term rates are near zero and have nowhere to go but up, though they are not likely to spike in the short run because the economy is expanding so slowly. When rates eventually increase, expect to see lower bond returns, possibly losses.

"It's a phenomenon that bond-fund investors haven't faced in a very long time," said analyst Loren Fox, of the fund-industry consultancy Strategic Insight. "Some will be surprised and disappointed when it happens." Indeed, investors have become accustomed to declining rates for the better part of 30 years.

Here are some key things to know about bonds:

Definition. At the most basic level, bond investors are lending their cash - to a company in the case of corporate bonds, or to government in the case of U.S. Treasurys or municipal bonds. Bonds are considered safer than stocks because there is typically a low risk that the borrower will not repay the loan when it is due, or default by failing to make scheduled interest payments.

Yield. This is the amount an investor receives for holding a bond until the date it matures or principal is repaid, expressed as a percentage. Interest to investors is paid regularly through coupon payments. The coupon is the annual rate of interest divided by the purchase price, meaning a bond selling for $1,000 with a 5 percent coupon rate offers a 5 percent current yield.

Price. Unless a bond is held to maturity, the return investors receive is also a function of price changes. That bond that yielded 5 percent at a price of $1,000 would yield 10 percent at a price of just $500. As a bond's price falls, its yield rises, and vice versa. Prices change because investors continually process new information about risks they face from interest rates, inflation, and potential for default. If investors can buy newly issued bonds paying higher interest than previously issued bonds, the value of the older bonds declines.

Individual bonds vs. funds: Investing in a bond mutual fund, rather than an individual bond, means an investor faces less risk. Bond funds typically hold diversified portfolios of hundreds of bonds; if just a single bond defaults, the effect is likely to be modest. But investing in a bond fund means paying fees for professional expertise, with no guarantee of returns superior to those investors could get on their own, or by investing in a low-cost bond-index fund.

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