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Knowing when to switch

As the stock market short-circuited, bonds powered more portfolios. But now might not be the time to buy them.

By HELEN HUNTLEY, Times Staff Writer

© St. Petersburg Times
published October 27, 2002


Watching their stock funds shrivel and their retirement dreams fade away, many investors who once ignored bonds are now scrambling to buy them.

"We've had so many people say "I don't ever want to see another stock again. Give me bonds,' " said Greg Ghodsi, a broker with Robert W. Baird & Co. in Tampa.

But if you are among those considering bond investments, this is a time to tread very carefully. It is just as possible to get burned by bonds as it is by stocks, and bonds may be on the verge of a decline in value.

"There are a lot of people who are in this market for the first time and don't understand there is some risk here," said Bill Hornbarger, fixed income analyst for A.G. Edwards in St. Louis.

In fact, most investors do not understand how bonds work, according to a survey Vanguard Group and Money magazine conducted last month.

Bonds are often perceived as a safe, stable investment, but they are neither as safe nor as stable as people think. Bond investors face several big risks, from the possibility of issuer defaults to returns that may not keep pace with inflation.

The risk that worries the experts most right now is the possibility of rising interest rates, which would hammer bond values. Bond prices and interest rates move in opposite directions, and right now interest rates are near historic lows. Hornbarger said the mortgage refinancing crush is a sign that the next interest rate move is likely to be up.

"Mortgage refinance activity tends to peak at around the time that bond yields trough," he said. "If you have refinanced your mortgage, you have already made a bet that interest rates are going to go up. Is that a good time to be buying long-dated bonds? No."

Interest rates are low now because the economy and the stock market have been down in the dumps. There are fewer borrowers because corporations don't want to expand in a downturn. At the same time there are lots of willing lenders, the investors who are buying bonds as an alternative to stocks. As the economy and the stock market pick up steam, those factors are likely to reverse. In fact, with the recent stock market rally, interest rates already have begun inching back up.

"I feel the future is much clearer than it usually is," said St. Petersburg investor Roy Dickson, 56. "I don't like the climate for bond investing. If you buy a lot of bonds right now, you'll be sitting with something you have a loss in for most of the time you own it."

He and other veteran bond investors on the Times Money Panel say they still believe in bonds, but they are not making many new investments.

"The only buying I've been doing recently is to replace bonds that have been called" for early redemption, Dickson said. A retired bond trader, he said investors should buy bonds for the income they produce and plan to hold them to maturity rather than count on being able to sell them at a profit or even for what they paid.

Investors who buy individual bonds as Dickson does can simply hold on, collect their interest payments and ignore interest rate fluctuations in the market. When the bond matures, they get their money back so long as the issuer has not defaulted.

Bond mutual funds own many different bonds, which reduces the impact of defaults, but a fund never matures. If bond prices fall, there is no guarantee investors will ever get their money back no matter how long they hold onto their shares.

However, bond funds are the only practical way to buy bonds for many investors. Supersafe bets such as U.S. Treasury bonds pay modest interest. On the other hand, buying riskier individual bonds is a bad move unless you have enough money to put together a diversified portfolio. That generally costs $100,000 or more.

With both bond funds and individual bonds, focusing on shorter-term investments reduces risk because short-term bonds, which mature in a few years at most, are less affected by changes in interest rates. The problem with that approach is that shorter-term bonds also have lower yields, not an attractive feature for investors looking for income.

Financial experts recommend bonds to provide steady income and ballast for navigating the financial seas. A balanced portfolio of stocks and bonds is much less volatile than one overloaded with stocks. For most of the 1990s, that balance tilted in one direction. Bonds lagged stocks and dragged down the overall performance of a balanced portfolio. Then bonds became the star performers as stocks fell lower. That's what convinced many investors that bonds are not so bad after all.

"Stocks have had the best return, but you can't put all your eggs in one basket," said Robert Kilgore, 60, of Brooksville, a retired financial adviser and Money Panel member. He said he has 52 percent of his money in stocks, with the rest in bonds and cash.

Kilgore said the time to buy bonds is when yields are 7 to 8 percent. These days many municipal and government bonds yield 5 percent or less.

Right now Kilgore thinks stocks offer better value, but investors have to be careful to pay attention to quality.

"When the tide goes out, it takes all the boats with it," he said. "When it starts coming in, it doesn't bring them all back. You have to be in the right boat at the right time."

Clearwater investor Robert Granger, 58, said he wishes he had been smart enough to put half his money in bonds three years ago.

"You figure out how much money you need to retire, then you get to that goal and you don't protect the goal," he said. "We all got greedy and left too much money in the stock market. We figured we needed a million dollars to retire, but we left it in some relatively aggressive things, and now it's down to $600,000 or so. I don't even know exactly, it's so depressing."

Granger, who retired from automotive parts sales, recently returned to work and now sells cars.

He said he cannot put half his money in bonds at this point because he needs higher returns to rebuild his portfolio.

"I hope I'm smart enough when I get back to a million dollars to move it into safer havens," he said.

The safest bet for most investors is to maintain the same stock-bond balance through thick and thin. Those who load up on whatever has been hot lately are the most vulnerable when the pendulum suddenly swings in another direction.

Charles Settgast, 65, of Pinellas Park said investors naturally want to put their money where they think it will get the best return and will not be willing to permanently settle for today's low bond yields.

"When investors think stocks will go up 10 percent, the money will start flowing out of bonds into stocks, so I am buying stocks instead of bonds," said Settgast, a retired executive.

James Steele, 61, of Clearwater, said he has chosen to keep a heavy cash position -- about 25 percent of his portfolio -- rather than buy bonds at current interest rates. He said he is waiting for the right opportunity to put the money to work.

Baird broker Ghodsi said most of his clients are doing the same thing.

"I can't in good conscience sell them a bond that I think is going to go down in price," he said. "I might be wrong. Maybe interest rates will go lower. But if I feel that way, I don't want to do it."

He said investors should be particularly cautious right now about buying closed-end bond funds, which trade like stocks. Many of them use borrowed money to improve their yields. Ghodsi said rising interest rates will be a double whammy for those funds since their borrowing costs will go up just as the value of the bonds they own goes down.

Default risk is also on many investors' minds these days. Safety-conscious investors can deal with it by buying U.S. Treasury bonds or AAA-rated municipal bonds. Odds are extremely good they will get their money back at maturity, though in the meantime they will give up the higher yields they could earn with riskier bonds.

More and more investors are dabbling in the world of corporate bonds, where the yields are higher but the default risk is very real. Settgast said he learned about risk the hard way.

"I looked at WorldCom bonds a couple of years ago and said "Gee, that's a well-thought-of company,' and it was paying close to 7 percent. I thought "That's a pretty good return,' and now I'm stuck with a whole bunch of bonds that are in default."

One of the hottest new products these days for small investors is direct-access corporate bonds. Companies take orders through brokers for new bonds, which are then issued at face value to investors. A bonus is that they can be redeemed at face value when the investor dies. Issuers include names such as Bank of America, Household Finance Corp., Dow Chemical, Caterpillar Tractor and Freddie Mac.

"You just have to be careful with overloading with any one name," broker Ghodsi said.

While the Money Panel bond investors are not rushing out to buy bonds, they are not dumping the ones they own either.

"I need the income," Dickson said, "so I'm not going to stick it all in a money-market account and try to make an interest rate bet."

-- Helen Huntley can be reached at huntley@sptimes.com or (727) 893-8230.

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