TSC Schoolhouse: Bonds Primer: Why Bother with Bonds?

Would you accept a somewhat lower return if it meant considerably less risk? If so, you're in the market for bonds. Lowering risk is basically what bonds are all about.

Bonds aren't foolproof. It's possible to lose money in bonds. In 1994, the worst year for bonds in a generation, lots of investors learned that lesson. Interest rates rose so much and so quickly that the paper price losses on many bonds were greater than the income they generated.

But 1994 was probably close to as bad as it gets. Over the long term, bonds have produced healthy returns -- much higher than money market funds have, and respectable even compared with equities. From 1987 to 1997, measuring from year-end to year-end, the Merrill Lynch Treasury Master Index returned an average of 8.9% a year, and Merrill's U.S. Corporate Master Index of investment-grade corporate bonds returned 10.1% a year. Those figures compare with average annual returns of 18.1% for the S&P 500 and 5.5% for taxable money market funds.

A portfolio of stocks and bonds makes more efficient use of risk than a pure stock portfolio, history shows. The basic principle is this: Adding bonds to a stock portfolio lowers its return -- but not as much as it lowers its volatility. This difference is what a measure called the Sharpe ratio tells you.

The Sharpe ratio calculates the difference between the return on an investment and the return on a risk-free investment (Treasury bills, for example), and divides it by the investment's standard deviation, the most common measure of volatility. The ratio tells you how much excess return the investment has delivered per unit of risk.

According to an analysis by Ibbotson Associates, from 1972 to 1997, a portfolio consisting entirely of the S&P 500 returned an average of 13.1% a year, while a portfolio consisting of 25% intermediate-term government bonds and 75% stocks returned an average of 12.2% a year.

But the more diversified portfolio came with less risk. The stock-bond portfolio generated a Sharpe ratio of 0.44, compared with a lower 0.43 for the all-stock portfolio, indicating that it generated as much return per unit of risk. In fact, it generated a tiny bit more. It's that same return on a smaller amount of risk that prompts Charles Schwab Chief Investment Officer Steve Ward to call diversification "the only free lunch."

There are other reasons besides risk-cushioning for investing in bonds. They are the mainstay investment vehicle for late in life, when you're done accumulating capital and need a steady stream of income. They're are also a strong option for saving. If you know you're going to need a sum of money on a particular date in the future -- to pay college tuition bills, for example -- you can buy bonds that come due at those times. In general, though, bonds are for protection from the vicissitudes of the stock market.

Have we whetted your appetite? That was the point. Now for the bad news: As much as bonds are supposed to be the stable, low-risk portion of your portfolio, the world of bond investing is still rife with pitfalls. Consider:

You can't just buy bonds and assume you have a low-risk investment. Bonds are complicated instruments compared with stocks, involving credit risk (the risk the issuer will default), and interest-rate risk (the risk that interest rates will rise, making bonds issued when rates were lower worth less).

No bond is immune from interest-rate risk. But in general, bonds with longer maturities carry more of it. So it's possible to take a lot of risk with bonds, not only with low-grade (low quality) corporate and emerging-market issues, which have prices that can drop sharply in economic downturns, but also with issues of the highest quality because of interest-rate risk.

It's hard to know whether you're getting a good price. If you buy individual bonds as opposed to bond fund shares (which you should do only if you have upward of $25,000 to invest in bonds at the very least, unless you're buying Treasuries), you need to make sure you don't overpay. With stocks, your broker gets a commission. With bonds, instead of a commission, you pay an undisclosed markup on the price of the bond. What's important to you is how the final price you are paying compares with what other investors are paying for the same security.

Pricing data, though, is catch-as-catch-can, even for institutional investors with lots of money to spend, because virtually all bonds trade over-the-counter rather than on an exchange. And because many bonds are infrequently traded (individual investors typically hold bonds till they mature), prices based on recent transactions often don't even exist. For highly liquid Treasury bonds and notes, prices are widely publicized. But the Treasury market is the exception to the rule.

If you buy bond funds, the low returns relative to stock funds means fees and expenses eat up a bigger share. You need to watch fees and expenses as a stock fund investor, but you really need to watch them as a bond fund investor.

Bond investing has a raft of tax implications. Municipals are federally tax-free and state tax-free if you buy bonds issued in your state. Treasury bond interest is state tax-free, but other U.S. government bond interest isn't. And then there's the alternative minimum tax, which applies to some munis.

The stories we'll run this week are designed to help you avoid these pitfalls so that you can get the most out of the fixed-income portion of your portfolio. If you don't own any fixed-income yet, these stories should help you decide what to buy. Questions or problems with your fixed-income investments? Let us know.