Bonds have low investment risk but pull down your average returns. Is this what you believe?

The unglamorous bond can actually be an exciting part of a co-ordinated investment strategy, and allow you to offset investment risk in other parts of your portfolio, due to their counter-cyclical relationship with other investment vehicles, particularly shares.

For most investors, bonds are just one thing - ballast. Bonds can work well for income seekers, and, in the hands of an adept speculator, they can beat the stock market for long stretches. But this is not how most investors use them. Most buy and hold, rather than speculating.

There is a better way to get extra value from your bond investment. Bonds help in keeping a stock-focused portfolio sturdy -- steadily, predictably heading in the right direction for long-term returns.

After their moment in the sun during the 80s, bonds were neglected during the 1990s bull market in stocks. Investors parked ever more of their assets in equities, afraid to miss out on the exponential growth. But when the market tanked in 2000, stocks-only portfolios shattered. Better-diversified accounts, however, enjoyed much of the stellar performance without the crash landing.

It's All About The Ratio

The first fixed-income question for most investors is, what's the right ratio of bonds to stocks?

Michael Holland, manager of the Holland Balanced Fund, strongly advocates a 60/40 ratio of stocks to bond for most investors. With this ratio, investors can generally gain 80% of the stock market's long-run return but with only a moderate level of volatility along the way.

 

Bond Investing - Why Buy Into A Fund?

The primary advantage of these funds is that they simplfy your investment. Writing a check to a fund company takes less effort than buying individual bonds and can, for some investors, be worth a small annual fee.

Many financial planners criticise government-bond funds, though, because few bond funds feature a single maturity date. Most managers buy and sell to take profits or pounce on perceived bargains. This means that there is no way to guarantee the return of your capital in full on any precise date - one of the key reasons for buying bonds in the first place.

The only way to totally guarantee stability of principal is to buy individual bonds at issue and hold them to maturity.

Bond Investing - Keep An Eye On Your Investment

Stocks have no ceiling. In theory at least, share prices can rise continuously so long as earnings expectations keep growing. Bonds, though, run in cycles. They have ceilings -- and floors. Yields don't fall to zero or rise to infinity.

For that reason, they can't be treated like stocks. Watch a few different bond categories over time and you'll quickly learn to capitalize on their individual peaks and troughs. In early 2003, for instance, Treasuries looked very pricey, high-grade corporates were mending and junk bonds had come back from their 2002 collapse. Municipal bonds weren't sure what to make of a proposed cut in dividend taxes, which might lower their tax advantages for income investors. Every year has its own circumstances, which affect the value of your bond portfolio.

You need to learn how to "sense the Force" in your chosen bond markets.

Even before you become one with the bond universe, you can employ a mechanistic approach. Choose a stocks/bonds mix and rebalance to it once a year, based on current market values of your holdings. Employ a similar approach within your bond holdings. Pare back winners and reallocate more to losers - particularly important where you hold a significant proportion in high yield bonds.

You'll also have to decide what to do with the interest checks. In tax-deferred portfolios, they're best reinvested to avoid steep penalties.

In non-retirement holdings, income reinvestment helps build up bond allocations more quickly -- though you must weigh the costs and benefits. Interest is taxable in the year it's earned, regardless of whether it's reinvested.

Taking income from bonds actually helps cut investment risk even further, in one sense. If they get ploughed back in to principal, those interest checks are in play in the market. Alternatively, they are beyond the market's reach once they go into cash or get used for everyday expenses.

Of course, using investment income for everyday expenses in the non-retirement phase is akin to eating your seed wheat, so if you don't reinvest, at the very least put the money into a high-interest cash holding account until it comes time to rebalance.