But when rates fall, the longer-term bond benefits more.

By John Waggoner, USA TODAY
If you ever played on a seesaw as a kid, you found out quickly that balance was important. A 200-pound boy on the other side could send you flying into Mr. Smith's pool three blocks away.

Balance in your 401(k) retirement savings account helps, too, particularly the balance between stock and bond funds. Bond funds will often offset a downturn in stock funds.

But some analysts say bond yields, which have risen in recent weeks, could rise further if the economy starts growing faster than expected. Rising interest rates would push bond prices down and erode the value of the bond funds you own. So, if you're looking for a place for the conservative portion of your 401(k), consider cash or cash-like investments: money market funds or guaranteed investment contracts.

You don't have to bail out of bonds tomorrow. In the short term, the collapse of the housing industry, as well as problems in the subprime mortgage market, could slow the economy and push rates down modestly.

"We think housing prices will decline a couple of percent this year," says Ken Volpert, portfolio manager at the Vanguard Group. Lower housing prices typically dampen consumer spending, because people feel less wealthy when their homes decline in value.

But Dan Fuss, star manager of Loomis Sayles Bond fund, says that even with the subprime debacle, we could see another two or three years of gradually rising interest rates. Rising rate cycles tend to last a long time, and the most recent cycle is still relatively young.

"I don't think it's over," Fuss say.

Bonds vs. cash

For a bond investor, even one who's just invested in a bond fund in a 401(k) plan, understanding the terms is crucial. A bond is a long-term IOU issued by a company, a state or local government, or the U.S. government. It's not much different from a car loan or a mortgage — except you're the lender. You collect the interest until the bond matures, at which point you get your principal back.

Peculiarly, there's little difference right now in yield between a short-term bond and a long-term bond. The yield on the two-year T-note is 4.8%, vs. a 5% yield on the 10-year note. Normally, investors would receive much higher yields from a long-term bond than a short-term, in part because long-term bond prices are more volatile than short-term bond prices: As interest rates rise, a long-term bond loses more value than a short-term bond. But when rates fall, the longer-term bond benefits more.

Similarly, investors typically receive far higher yields for buying bonds issued by companies with low credit ratings. Not now. "You're not getting paid to take a lot of risk," Volpert says.

So what's an investor to do?

•Consider money funds. The average money market mutual fund yields 4.7%, according to iMoneyNet, which tracks the funds. Many of the bond funds in your 401(k) plan probably have similar yields. Pimco Total Return, (PTTAX) the nation's largest bond fund, has a current yield of 4.43%. Vanguard Total Bond Index, (VITBX) the second-largest fund, yields 5.3% And the American Funds Bond Fund of America,(ABNDX) the No. 3 bond fund, yields 4.9%.

The difference between your money fund and your bond fund: Your money fund is far less likely to lose value. Though they aren't guaranteed, money funds have a solid long-term safety record.

•Consider a guaranteed investment contract. GICs are CD-like investments offered by insurance companies, and a staple of 401(k) plans. Sometimes they're called "fixed-income contracts." They now yield more than 5%.

If you do want to stay the course in bonds, you can improve your returns considerably if you rebalance periodically. First, allocate a percentage of your 401(k) to bonds — say, 25%. Every year, make sure your portfolio contains that same allocation. If your portfolio now includes 30% in bonds and 70% in stocks, for example, you'll have to sell enough of your bond holdings to restore your allocation to 25%.

By rebalancing, you'll, in effect, be selling your stock funds when they're high, and buying bond funds when they're low. Don't rebalance too often. In fact, if you rebalance only when your stock/bond allocation falls off by 5 percentage points or more, you'll fare better than if you rebalanced quarterly. If you rebalance too often, you run the risk of cutting short your winning funds and shoveling money into funds that are still falling.

Why cash now?

Bonds are usually a good complement to a stock portfolio, even though they tend to return less, over time, than stocks do. Bond prices often rise when stocks fall, and a bond's income helps offset stock declines, too.

Unfortunately, bonds, too, must endure bear markets. Bond-market downturns aren't typically as severe as stock bear markets. But they can reduce your overall returns. Bond prices fall when interest rates rise (see chart), and rates have been rising since June 2003.

Funds that invest in U.S. government bonds have gained an average of just 2.2% a year over the past four years, according to Lipper, which tracks the funds. Adjusting for inflation, you'd have lost money in government bond funds during that period. If interest rates continue to rise, as some analysts expect, bond funds will continue to falter. What would cause rates to rise?

•Higher rates abroad. The U.S. has trillions in debt, much of it financed by selling Treasury securities. If the recent rise in European interest rates continues, bond traders will demand higher yields on Treasuries, too.

•Inflation fears. "Core" inflation, which omits volatile food and energy prices, has risen at a tame 2.2% since May 2006. But if you include food and energy, inflation has gained 2.7% — and 0.7% in May alone.

The Federal Reserve, the nation's central bank, isn't yet convinced that inflation is dead. If the Fed pushes short-term rates higher to slow the economy and reduce inflation, long-term bond rates could rise, too.

•Wage pressures. Rising commodity prices are one part of the inflation formula. Rising wages are the second part. The unemployment rate now stands at 4.5% — well below the 5% threshold that economists consider "full employment." Wages for civilian workers gained 3.6% the 12 months ended March, vs. 2.7% for the 12 months ended the same period in 2006.

"If I were on the Federal Reserve's Open Market Committee, I'd be reluctant to lower rates," says Fuss, the bond fund manager.

Bond prices rise when interest rates fall. If you own a $1,000 bond that yields 5%, and newly issued bonds pay only 4%, investors will pay more than $1,000 for your bond. When bond prices rise, you win twice: You collect interest and reap the price gains when you sell.

Bond prices fall when rates rise. If newly issued bonds yield 6%, you'll have to cut your 5% bond's price to attract buyers. Your bond's price losses might exceed your interest payments.


7/7/07