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Billions of dollars have flowed out of stocks and into bonds over the past 18 months, and it's easy to see why. While stocks dumped yearly double-digit losses on investors between 2000 and 2002, bond portfolios trumped the major stock market indexes three straight years, the first time that's happened since FDR had nothing to fear but fear itself. Investors who sought safety in fixed-income over the past year, though, should be afraid of something more tangible--bond prices may be on the verge of a nasty downturn themselves.
The problem is that investors by the millions moved sizable portions of their nest eggs into bonds at what could turn out to be the worst possible time. In a fool-me-twice scenario, an investor who took a big hit from stocks finally throws in the towel and moves her money into bonds just in time to take another hit, this time from supposedly safe bonds.
Blame Alan Greenspan. The Federal Reserve chairman helped ease the economy into his "soft landing" recession by steering short-term interest rates to their lowest level in decades, making it easier to refinance mortgages, buy cars and in general spend enough money to keep Corporate America working. But what goes down must eventually go up. If and when the economy improves, interest rates will rise again; and bond prices, which move in the opposite direction of interest rates, will fall.
The downturn will be painful, too, especially for mutual fund investors. In 1994, the last time the Fed had to raise interest rates multiple times, some bond funds shed more than 25 percent of their value. In other words, trying to "time the market" by moving all your money into one type of investment is no less risky with bonds than it is with technology stocks.
It may be your father's investment advice, but the surest way to minimize risk is by keeping investment dollars spread among stocks, bonds, cash equivalents and real estate. Even within bond holdings, though, there are steps you can take to put a safety net under your portfolio.
Long-term treasuries are most sensitive to interest rate movements, so try to shorten the maturities of your government bonds. Also, put investment dollars into various types of fixed-income holdings, including emerging-market debt, high-yield bonds, municipal bonds and inflation-adjusted treasuries. Another option: Buy individual bonds, as opposed to bond funds, which allows you to hold on until maturity and at least guarantee that you will get your principal returned intact.
Scott Bernard Nelson is a financial writer at The Boston Globe.