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Putting stock in bonds

Many investors watched in gut-wrenching shock as the stock market plunged on Feb. 27, afraid the decline might mark the start of a crash that would wipe out their savings.

Not Robert Youker. The retired World Bank employee's holdings in ultra-safe Treasury securities scored big gains that day while the Dow Jones industrial average tumbled more than 400 points.

"It didn't bother me at all," Youker, 73, of Bethesda, Md., said of the Dow's drop. "I have a lot more money in bonds than in stocks. ... I don't worry at all about the stock market."

Youker's serenity is what many small investors pay for when they buy traditional bonds. Assets that are steadier, stodgier and less flashy than stocks but also less risky. Smaller returns on average over time but fewer stomach-churning ups and downs.

And with the stock market turning choppy in recent weeks, many individual investors are looking for alternatives.

The bond market — with its arcane vocabulary, esoteric products and legendary machismo — can be intimidating.

But anyone with an Internet connection and some patience can see that it's also getting easier for individuals to learn about and invest in bonds. Web sites have proliferated offering glossaries, research and technical help for those who want to get started.

A bond is essentially an IOU. A government or company needs to borrow money. So it sells, or "issues," a bond for a specific amount to investors, promising to repay that amount with interest over a certain time period, on specified terms. Typically, the bond issuer pays only the interest until the end of the period, when the bond "matures" and the original amount, or "principal," is repaid.

For example, say XYZ Co. wants to borrow money to expand its factory. It issues a five-year, $1,000 bond at 4 percent interest. The bond buyer gives XYZ Co. $1,000 and receives $40 in interest each year. At the end of five years, the investor gets back the $1,000 and has gained $200 in interest.

For individual investors, bonds' primary appeal is the guarantee of receiving income plus the original investment back. That, and a simple way to diversify a portfolio by adding something that tends to zig when stocks zag. Like throwing a pair of sensible shoes in the closet alongside the zippy heels.

Bonds can also be bought and sold after they are issued, and their value on the market can change from their price when issued. Many investors hold their bonds until maturity, feeling no effects of price swings. But an investor who has to sell when prices are down will lose money.

Youker, for example, said he lost money when he sold bonds issued by General Motors' finance subsidiary, GMAC. But he is holding on to his Ford bonds, though they have sunk in value as the company's losses have mounted. The Ford bonds pay a relatively good 7 percent interest rate and mature next year, he said.

One of the risks with bonds is that the issuer might default, running out of money to make the payments. The Russian government, for example, defaulted on some of its debt in 1998. Many Internet and telecommunications companies that issued bonds during the tech stock boom defaulted after they went bankrupt.

Among the safest bonds in the world are Treasurys, the securities issued by the Treasury Department to raise money for the federal government. Investors consider them virtually risk-free because a U.S. government default is so unthinkable.

Treasurys can be bought directly from the government online, through the TreasuryDirect Web site, with no fees or commissions. Youker said he buys the securities from his home computer, the principal is deducted from his bank account, and the interest is deposited into his account automatically.

Also considered relatively low risk are "munis," bonds issued by states, counties and local authorities to raise money for roads, schools, stadiums and other public projects. But munis aren't considered default-proof like Treasurys.

A key selling point for Treasurys and munis is their tax advantages. The interest from Treasurys is exempt from state and local taxes. Interest from most munis is exempt from federal tax and is usually exempt from state or local taxes if the investor lives in the same locality as the issuer.

More adventurous investors can venture into "corporates," bonds that are issued by companies and vary widely in their perceived risk. Last year, U.S. companies issued a record $1.05 trillion worth of bonds, up nearly 40 percent from the previous year, according to the Securities Industry and Financial Markets Association (SIFMA), which represents banks, asset managers and investment firms.

Credit conditions for big borrowers last year were "as good as it gets," said Michael Decker, head of research and public policy at SIFMA in Washington. "The big drivers of activity in the bond markets last year were healthy economic growth, low long-term interest rates, favorable credit conditions and a global abundance of capital seeking investment opportunities."

That meant bond issuers could borrow cheaply, but investors earned small rates of return.

Market conditions have shifted since the recent stock market plunge, as jittery investors have demanded higher rates of interest on corporate bonds, widening the so-called "spreads," or differences in rates between corporates and Treasurys. That makes borrowing more expensive for companies, but more rewarding for bond buyers.

To help investors, bonds are ranked by credit-rating agencies according to their risk, with the top ratings going to companies considered least likely to default. The lowest, or "junk," ratings get slapped on the bonds of those most likely to default. Ford and GM bonds, for example, fell to junk status in recent years.

Corporate defaults have been rare recently. The default rate for U.S. corporate bonds was 1.32 percent at the end of February, according to rating agency Standard & Poor's, compared with a 25-year average rage of 4.5 percent. But the firm forecasts the default rate to rise as the economy slows, to 2.3 percent by yearend.

Part of the interest rate paid on a bond is compensation for the risk of default over time, with the riskiest debt carrying the highest rates. And issuers usually pay higher rates on bonds of longer durations because of the greater potential for things to go wrong.

Another part of the interest rate is compensation for inflation, which erodes the value of the principal over time. One risk with bonds is that inflation will rise higher than anticipated. Bond interest rates are influenced by Federal Reserve policy but ultimately are determined in the global capital markets.

If inflation rises, new bonds will be issued at higher interest rates. That's great for buyers of the new issues. But investors holding older bonds issued at lower rates will find them harder to sell, driving their price down. So as rates go up, prices go down, and vice versa.

Financial advisers say one way to guard against inflation risk is to buy Treasury Inflation-Protected Securities, or TIPS, which adjust the value of the principal amount to keep pace with price changes. But they also say TIPS tend to be better investments when inflation is high than when it is low.

Interest rates have been historically low since the 2001 recession, prompting frequent predictions that they are bound to rise. But that hasn't happened, underscoring how difficult it is for even professionals to time the market. Financial advisers say individual investors should not even try.

"I wouldn't try to time the market short-term unless you have a lot of time and can swallow an unlimited amount of aspirin," said Daniel Fuss, co-manager of the flagship mutual fund at investment firm Loomis Sayles in Boston.

One way to avoid such headaches is to invest in a multi-sector bond mutual fund, which combines munis, corporates and other types of bonds of different durations, he said.

Another way is to construct a so-called laddered portfolio of bonds with different maturity dates. For example, say you have $50,000 and put $10,000 each into five separate bonds that mature in one, two, three, four and five years. Then every year, you'd have a bond maturing, paying you back the principal, which you can use to buy another five-year bond. Because you are investing only part of your savings each year, at various rates, you smooth out the bond market's ups and downs.

In deciding whether and how to invest in bonds, investors are always advised to think about how much risk they can tolerate, their investment goals and their time frame for investing.

Advisers commonly suggest investors put most of their money into stocks when they are young, to benefit from the higher returns, because they have many working years ahead during which they can ride out the market's swings. Then, as investors approach retirement, they can shift more of their savings into bonds. And after they retire, they might prefer to have most of their money in bonds both for security and income.

However, this process, called portfolio allocation, can vary widely depending on investors' appetite for risk.

Youker, for example, said he knows he might make more profit by investing more in stocks, but he explained his choices by quoting the old adage: "Do you want to eat well or sleep well?"

Bonds: A Primer

Bond: A debt instrument, essentially an IOU, issued by governments or companies that is repaid with interest.

Coupon: Interest payment on the bond.

Yield: Total return on the bond investment, including interest rate and price, expressed as an annual percentage rate.

Treasurys: Issued by the Treasury Department to raise money for the federal government. They vary in duration, from three- and six-month bills through two-, three- and five-year notes, to 10- and 30-year bonds.

TIPS: Treasury Inflation-Protected Securities adjust the value of the principal amount to keep pace with price changes.

Munis: Issued by states, counties and local authorities to raise money for roads, schools, sewers, hospitals, stadiums, airports and other municipal projects.

Corporates: Bonds issued by companies.

On the 'Net

www.treasurydirect.gov, a site run by the U.S. Treasury.

www.investinginbonds.com, a site run by the Securities Industries and Financial Markets Association, the trade association of firms that sell stocks and bonds.

www.bonddeskgroup.com. BondDesk is a service that connects investors with bond dealers and allows investors to do their own research and buy bonds themselves.

Also: The Web sites of all the major mutual fund companies offer primers on bond investing.

The Washington Post