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What Should I Do About My Bond Portfolio?

Relax, and take a long-term perspective on the fixed-income side of your portfolio.

It's 13 weeks into a stock market rally. Do you know where your bond funds are?

Investors sharply pulled back from bond funds in June, according to Lipper, a

Reuters

company. Bond funds saw net inflows reduced by 25% from May, to $6.5 billion. That makes June the smallest month for inflows since October 2002, and the fourth month of steady shrinkage.

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The reasoning is twofold: Bond prices dropped midmonth, making market-timers fear a slide, and the stock market's 30% rise since this rally began seemed reason enough to shift investing focus.

"There's been a gradual return of some confidence in equities; that's been a major factor," says Don Cassidy, a senior research analyst at Lipper. "People are definitely shifting from bonds to equities, but that's more a matter of timing the equity market than the bond market."

But before you join the masses of investors who just realized that (A) stocks will indeed recover and (B) bonds are not risk-free, take a moment to evaluate your bond portfolio. "There are a number of reasons to stick with bonds," says Morningstar analyst Scott Berry. "Diversity is as important now as it's ever been."

As with stocks, bond investors should learn to eliminate the noise of daily price movements. There's been some consternation of late, for instance, of a sudden upsurge in long-term Treasury yields. But yields, despite having gone up roughly a whole percentage point in the past week, are still at multidecade lows.

So rather than focusing on short-term twitching, Cassidy says, think about the long-term economic scene. "Look at the big picture," he says. "Consider two questions: Which way is the economy going, and which was is the

Fed

pushing interest rates?"

Indeed, a lot of the selling that drove long-term Treasury yields higher was the sort of noise that should be ignored. "Much of that selling was technical," says Mark Kiesel, a portfolio manager for bond powerhouse Pimco. "Mortgage bonds are expanding to longer maturities, which means the overall duration of portfolios that hold mortgage bonds is extending. To compensate, they have to reduce their holdings in other long-term instruments -- like long-term Treasuries."

Given

Federal Reserve

Chief Alan Greenspan's relatively sanguine testimony two weeks ago, it seems clear the Fed is

not

going to be buying long-term Treasuries (which it would do if it wanted to hold down long-term interest rates as a deflationary precaution) and will keep the overnight/federal funds rate at 1% as long as he has to. "But with the Fed not raising rates anytime soon and inflation still falling, real yields

the nominal yield -- the coupon divided by the price paid for the bond -- minus the inflation rate are still pretty attractive," Kiesel says. "Thirty-year Treasuries have a 3.5% real yield, and that looks OK to us -- especially in an economy that's subpar."

In fact, Kiesel expects those real yields to look OK to other bond investors as well. "In the second half of this year, I think we'll see some movement out of stocks and back into bonds," he says.

Succumbing to the whims of fund flows is never a good idea, no matter which direction you're heading. But as for economic calls, Cassidy thinks the flight from bonds is a bit premature. "We still have a fairly neutral picture," he says. "We need a year to see if the economy gets stronger, if the tax package helps anything. When the Fed revises its policy and starts raising rates, that will send a clear signal."

While a diversified bond portfolio should have a bit of everything -- Treasuries of varying durations, corporate and even high-yield bonds -- investors can adjust the mix according to their view of the economy. "When you're buying bonds you're implicitly making a bet," Cassidy says. "It pays to take five minutes to think about what you're betting on."

If you buy that the economy is getting moderately stronger, then move some money into high-yield or convertible bonds, Cassidy says. "That way you get the benefit of stock appreciation, too," he says. Pessimists, of course, would continue to buy long-term bonds. "And if you don't know where the economy is going, buy TIPS," Cassidy says.

TIPS, or Treasury Inflation Protected Securities, are Treasuries that have a built-in mechanism that compensates for inflation, so your return won't be diminished in an inflationary environment. (For more on TIPS investing, see "

Investors Take TIPS to Beat Inflation.") "With monetary and fiscal policy engines working to accommodate inflation, TIPS are a good idea now," Kiesel says, adding that Pimco portfolios have been accumulating TIPS of late.

Which brings us back to a very good point -- if you're not up to making broad economic bets, fund investing is, as always, the best way to go. You can go with broad spectrum, actively managed funds like Pimco's venerated

(PTTAX) - Get Report

Total Return, or those that track an index, such as Vanguard's

(VBMFX) - Get Report

Total Bond Market fund.