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Bonds too risky right now

Question: I'm nearing retirement and I'm aware of the standard advice that I should be putting an increasing portion of my investments (in my case, 403b and 457 plans) into bonds. However with interest rates at such historic lows, I can't understand how this can be a good thing. There isn't much room for interest rates to go anywhere but up, and that means any bonds I buy now will simply go down in value. Can you help me understand the situation better? Should I really invest more in bonds? John, Minneapolis, MN

Answer: You're right to be wary. Investors are starting to flee bonds. The case that the economy is gathering momentum is increasingly credible. The stock market is rallying on speculation that the rise in interest rates will continue. The 10-year note yields 3.39% as I'm writing this, is up from up from 2.49% in early November. The rise in rates is healthy. However, from the point of view of a retiree higher bond yields means lower bond prices. It's in the nature of the investment.

Here are three suggestions for dealing with the risk while keeping a substantial portion of your portfolio in fixed income securities. (My assumption is that you're investing in high quality, safe securities like U.S. Treasuries, federally insured certificates of deposit, and the like.)

First, you can keep your fixed income money in the shorter end of the market. As those bills and notes mature you can purchase comparable but higher yielding securities. The price for this strategy at the moment is an abysmally low yield on investment. A look back at U.S. financial history suggests with this approach you'll pretty much match the rate of inflation.

Another strategy is to create a fixed income "ladder." The idea is to invest in U.S. Treasuries (or CDs) with different maturities. For example, you invest equal amounts in three-month, one-year, three-year, and five-year Treasuries. Key to this technique is the longer the maturity date the higher the yield. Now, let's say interest rates go up. You'll have some short-term debts that will mature soon, and you can reinvest that money at a higher rate. If rates stay low or even fall you're still earning a better return on your higher yielding fixed income securities.

Henry Hebeler has an article at Analyzenow.com that explains the mechanics of a bond ladder in much more detail. It's called Laddering CDs and Bonds and you'll find it in the "Investment" section of the Helpful Articles portal.Jane Bryant Quinn also gives a clear exposition of bond laddering in Making the Most of Your Money Now: The Classic Bestseller Completely Revised for the New Economy.

Last, you can the money into TIPS or Treasury Inflation Protected Securities. The focus of this strategy is hedging the value of your savings against the ravages of inflation--and make a little interest along the way. TIPS are the long-term savers' friend.

Inflation-indexed Treasury bonds come in 5, 10 and 30 year maturities with a minimum purchase of $100. TIPS offer a fixed interest rate above inflation, as measured by the consumer price index. An additional advantage of TIPS is that they protect against deflation--a decline in the overall price level of goods and services--by offering a "deflation floor" that protects principal value during deflation. Default risk is nonexistent, since these are obligation of the U.S. government.

That said, for legal and regulatory reasons you can't buy TIPS directly from the U.S. Treasury for your retirement savings account. (You can buy them directly from the Treasury for a taxable account.) You'll have to pay a broker to do it for you. It's worth it, however.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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