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Gary Karz, CFA (email)
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Background

     The major benefit of investing in bonds is that they provide current income and some degree of stability of capital. In general the shorter your investment horizon and the lower your risk tolerance, the higher percentage of bonds you'll seek. The major disadvantage of bonds is that they underperform stocks and some other investments over the long term. Historically stocks have provided substantially greater returns than bonds, however there are good arguments for investing in bonds for the long term. According to James Paulsen (Senior Managing Director, Investors Management Group in Des Moines, Iowa), from 1870 to 1940 bonds had returns almost equal to stocks, but with less volatility. He claims most of stocks outperformance occurred from 1942-1962 during abnormally strong real economic growth (Source "Are Bonds A Better Bet Than Stocks?" in Pensions & Investments, 6/24/96.). During the first decade of this century, bonds in fact outperformed US stocks. Regardless of the period, many believe bonds should be considered as a major component of a diversified efficient portfolio.

     Bonds markets are considered very efficient and fees should be examined carefully and ideally avoided entirely if possible. Worth magazine ran an article in November 1996 titled "Losers out the gate" which began "Let's be blunt: government securities mutual funds don't deserve to exist." The reasoning being that "In this part of the fixed-income market, coughing up management fees for active management almost never pays off." David P. Goldman expressed similar thoughts in his 10/21/96 Forbes article titled "When bond fund managers get bored" which discussed how little active management can increase returns when the yield spread between 30 year corporates and 30 year treasury securities is under 1%. "The lesson here for mutual fund investors is this: There's little point owning a mutual fund that invests in high-grade corporates right now because there is little the manager can do to earn his keep." See also Bonds at Wikipedia, Bonds vs. Bond Funds at Bogleheads, and Bond vs. Bond Funds (9/29/2000) from Smartmoney.

     Its important to note that bond ratings can and do change and the spreads between ratings move accordingly. Over an investment horizon, returns are determined by the initial spread, changes in the spread, and transitions in credit quality (changing ratings). The value of bonds can also fluctuate dramatically as interest rates rise and fall.

"Mountains of junk bonds were sold by those who didn't care to those that didn't think -- and there was no shortage of either."
     Berkshire Hathaway Annual Report, 1990, 18.

See also Asset Allocation and Historical Returns

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