Bonds have higher yields then stocks. Bond funds have higher yields then stock funds. This means more current income for you. Bonds and bond funds are (generally) safer then stocks and stock funds.  They fluctuate less in value. That’s good, too. So what’s wrong with this picture? Bonds are fixed income securities. Their income doesn’t grow, nor does their principal value. As a matter of fact, the real value of their principal declines over time due to inflation. 

 

Now, before you jump all over me, yes, there are inflation-adjusted Treasury securities that increase in value with inflation and floating-rate bank loan funds whose yield should increase if interest rates go up. Also, you can realize a (usually modest) gain in principal value if you buy a bond at less then its face value and hold it until maturity.

 

And, there are some managers who through astute analysis, forecasting and trading, add value and outperform a simple buy and hold strategy. However, superior relative performance becomes harder to achieve as you go up in quality, think: High yield (“junk bonds”) at one end of the scale and U.S. Treasuries at the other.  The same is true for maturities.  There’s not much a manager can do to create relative value with short term bonds. Value can be created by correctly forecasting (good luck!) interest rates and buying, or selling, long term bonds.

 

Bond funds have their place in your portfolio. It’s always wise to have a cushion for unforeseen expenses or just to be able to take advantage of an opportunity in the market or elsewhere. If you’re going to need cash at a certain time for events such as buying a house, college education, or the like, having the safety and certainty of a bond fund is a smart investment. Caveat: if you need funds at a not too distant date don’t speculate with a risky bond fund, you’ll be unpleasantly surprised with its volatility.

 

I fear that too many investors put too much money in bond funds and too soon in their investing careers. The income may be reassuring, or seductive, but the limited appreciation and the inflation purchasing power risk must be considered. There’s one more reason not to put too much capital in bond funds. Come back on Wednesday and I’ll tell you what it is.