Are Bonds Always the Best Alternative?

September 16, 2008
Joseph F. Lagowski

Physician's Money Digest, March15 2003, Volume 10, Issue 5

Many physician-investors retreatingfrom the volatile stock market havesought refuge in what they perceive asthe relative safety of bonds. As a result,fixed-income investments have performedwell in recent months. However,just as the stock market hit the stratosphere2 years ago and then came backdown to earth, the bull market for bondsprobably won't last forever.

CURRENT SUCCESS

Before discussing whether or notbonds are beneficial for your portfolio,let's take a look at why bonds have doneso well recently. In the past severalmonths, many investors have gravitatedtoward what they perceive as the relativesafety of bonds because of sinking stockprices and general market volatility. Theyhave done so because fixed-incomeinvestments offer fixed coupon yields (ie,annual interest payments) and, in thecase of Treasuries, the backing by the fullfaith and credit of the federal government.If held until maturity, Treasurysecurities and other fixed-income investmentscan preserve principle while guaranteeinga regular interest payment,which can be appealing to an investorlooking to avoid the volatility of stocks.Keep in mind if you sell your bond priorto maturity, you may receive more or lessthan your original investment.

Figuring a bond's current yield can helpyou measure your total return on yourcapital investment. You can calculate abond's current yield by dividing its couponrate by its current price. For example, if abond is selling at "par" or face value of$1000 and has a coupon rate of 6%, it hasa current yield of 6% (ie, $60/$1000 = 6%).

However, it is important to remembera bond's current yield has an inverse relationshipto price, meaning that if theprice paid for the bond goes up, its currentyield will decline. Conversely, if itsprice goes down, its yield will increase.Let's look at an example. If you buy thatsame 6% coupon bond but pay only $800for it, then the current yield would be7.5% (ie, $60/$800 = 7.5%). If the pricewent up to $1200 for the bond, its yieldwould fall to 5% (ie, $60/$1200 = 5%).

POSSIBLE DECLINE

Keeping all of this in mind, what doesthis mean to the stock investor who mayhave sought refuge in bonds? First youneed to ask yourself if you planned tohold the bonds to maturity. If so, you willcontinue to receive your annual couponpayments as prescribed and get your principleback in its entirety if you hold thebond until it matures.

However, if you might be interestedin selling your bonds before they mature,remember the inverse relationshipbetween the current yield of the bondand its price. This could create a situationwhere you might have to sell the bondfor less than you paid for it—somethingyou might want to avoid. Here's howthat scenario works.

Currently, interest rates are at lowsnot seen in more than 40 years, and it's afairly good possibility that rates won'tdrop much further. In fact, rates will likelyrise as the economy improves. As interestrates increase, new bonds will beissued with higher coupon rates andpeople will invest in them to take advantageof the higher annual interest payments.Demand for the bonds with thelower coupon rate will decline, causingprices for them to fall as well.

Bonds can be a solid addition to a balancedportfolio. When deciding how toinvest, you should consider the performanceof your portfolio over the longterm. Now is an excellent time to reviewyour portfolio, particularly your bondholdings. Your financial consultant canwork with you to make sure you aren'toverweighted in bonds, and can examineyour overall investment mix.

Joseph F. Lagowski is vice president,

investments, and a financial consultant with A.G.

Edwards in Hillsborough, NJ.

He welcomes questions or

comments at 800-288-0901 or

www.agedwards.com/fc/joseph.lagowski. This

article was provided by A.G. Edwards & Sons,

Inc, member SIPC.