NEW YORK ( TheStreet) -- Quick: How could you have easily beat the bull market in stocks from 1980 to 2008, when the Dow soared from 800 to nearly 14000? Answer: by owning bonds. "Starting at any time from 1980 up to 2008, an investor in 20-year Treasuries, rolling them over every year, beat the S&P 500 through January 2009," says financial forecaster John Mauldin. Despite the famous bull market in stocks that began in the early 1980s with the Dow trading around 800, the bond market outperformed stocks as interest rates fell. In the early 1980s, amid fears of massive inflation, yields on 20-year Treasuries were 15%. They've recently fallen to below 4%, generating tremendous profits along the way. Over the long run, history says that a portfolio of stocks will outperform a portfolio of bonds. But there have been some periods when bonds have beat stocks. In fact, we're nearing the tail end of one of those periods. People rarely praise the performance of bonds during the past 20 years, and no cocktail party discussion ever involved a hot tip on bonds, but suddenly bonds are moving to center stage. That's because everyone from your mother to your portfolio manager is suddenly searching for yield. With 10-year Treasuries now at 3.5%, and your mom's CDs earning less than 1%, there's a mad rush for income. Sadly, there's very little discussion of price risk, which will only become apparent in hindsight if inflation returns.
The global bond market dwarfs the global stock market. The market for bonds is estimated at $67 trillion dollars, with nearly half of those bonds originating in the United States. That compares to a global stock market valuation of just above $40 trillion, even after the market crash. Most of these bonds trade daily, just not as visibly as the prices set in the stock market. The opaque nature of the bond market leads to huge price differences and plenty of profit opportunities for unscrupulous brokers. Those wide spreads are giving financial companies an opportunity to narrow the spread and introduce retail consumers to a new, more transparent bond market. That's what's behind Fidelity Investments' recent push to teach investors about bonds with seminars and online tools. The company is trying to make it easier and cheaper to create portfolios of individual bonds, and choose appropriate bond funds. More than 100 fixed income specialists are available by phone to help customers. "They need to know that there is an alternative between stocks and cash or money market funds," says Richard Carter, vice president of fixed income securities at Fidelity's brokerage unit. "Bonds, whether individual securities or an appropriate bond fund, can fill that gap." Fidelity's Web tools enable wealthy investors to make a "bond ladder" of similar bonds maturing in successive years. A "scatter" graph allows you to set your risk parameters -- including coupon rate, maturity date and credit rating - and locate individual bond issues you can buy for your brokerage account. The new site offers everything investors need to become their own bond portfolio manager.
But those searching for higher yields these days, are unlikely to remember the bond market lessons of the 1970s, when inflation pushed rates higher, and many bond buyers found themselves stuck with long-term bonds at yields that were way below inflation. Before you start considering the role of bonds in your investments, you need to know some basics about the two risks in owning bonds. The first is called "credit risk," or the risk that a company might default on its interest payments. You can usually minimize this risk by purchasing bonds with high ratings from Moody's ( MCO) and Standard & Poor's. And you can minimize your overall credit risk by owning a diversified group of bonds. The easiest way to do that is to buy a mutual fund, so that portfolio managers can pick bonds for you. The second risk is related to interest rates. If you lend money for 20 or 30 years at a fixed rate, rising interest rates can make your bonds less attractive. In other words, if you buy a 20-year corporate bond that pays 5% today and the issuer sells more bonds at 7% tomorrow, your bonds will be worth less in the marketplace. One more basic: The longer it takes for a bond to reach its maturity date, the bigger the price swing. After all, it's better to be stuck with a low-yielding bond that matures five years instead of 20. Remember: As interest rates fall, bond prices rise, and vice versa. If interest rates were to rise sharply, amid fears of future inflation, bond prices would fall.
So we're back to that old question of inflation versus deflation. If you think the economy will remain slow, you can reach for slightly higher yields today on medium-term government or highly-rated corporate bonds. But if you fear inflation, don't buy bonds with maturities longer than 5 years; You'll take a loss if you sell them before maturity. A higher yield always offers a higher degree of risk. If you can't afford that risk, stick to short-term CDs or money market funds. That's The Savage Truth. -- Reported by Terry Savage in Chicago.