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Spotlight On Stocks May Be Obscuring Virtues Of Bonds
The stock market's incredible performance- Wilshire 5000 Total Market Index returned an average of 25% a year for the five years 1995 through 1999-has made investors keenly aware of the rewards of stocks. Given that the Lehrnan Aggregate Bond Index earned an average return of 8% during that period, it may be tempting to forget about bonds, grab the bull market by the horns, and focus only on stocks.
Cash flows into mutual funds suggest that investors have done just that. Americans put about $142 billion in net new cash in stock and balanced mutual funds during the first ten months of 1999, while adding a mere $13 billion to bond funds, according to the Investment Company Institute.
Although they are vastly outnumbered, contrarian investors- those who buy out-of-favor investments whose prices may not reflect their true value-may find bonds to be particularly attractive, despite fears of looming higher interest rates, which would cause bond prices to fall. This article addresses the benefits of bonds, both ontheir own merits and as part of an overall portfolio.

Interested In Income?
The key attribute of bonds- and bond funds- is income. Low-cost bond funds generally provide more interest income than stable-value investments such as money market funds or certificates of deposit. The trade-off for higher income is that share prices of bond funds fluctuate from day to day. But for long-term investors who can ignore price fluctuations, the income stream from bond funds is attractive, especially compared with stock dividends. The yield of the broad bond market, as measured by the Lehman Brothers Aggregate Bond Index, was 7.16% at year-end 1999, more than six times the 1.1 % dividend yield for stocks, as measured by the Wilshire 5000.
Keep in mind that bond prices typically move in the opposite direction from interest rates. Thus, rising yields during 1999 meant falling bond prices. For example, the yield on the 10-year U.S. Treasury bond rose from 4.65% to 6.44% during the year, while its price fell -12.5%. In the short run, price changes up or down can easily exceed the interest income from a bond. But over the long term, interest income-and the compounding of that income-is the driving force behind bond fund returns. So for investors with a longterm perspective, the rise in yields during 1999 could be a significant benefit. After all, when interest is compounding at a yield of 4.65%, it takes about 15 years for an investment to double, whereas at 6.44%, money doubles in just over 11 years.

Diversification And Risks
Although bond prices and yields fluctuate, the swings are usually less dramatic than those of stock prices. And bond prices sometimes rise when stocks fall. Because bonds and stocks don't always move in sync, bond funds can smooth out the returns in a portfolio full of stock funds. Importantly, the income and relative stability of bonds help many investors to endure both emotionally and financially- the stressful stock market downturns that are, of course, an inevitability.
All investments have risks, and bond funds are no exception. As discussed above, when interest rates rise, bond prices fall, so the value of your investment can decline.
The longer the maturity- the time until a bond is repaid-the more its price fluctuates as market interest rates change. If rates change by one percentage point, an intermediate-term bond fund's price may rise or fall twice as much as that of a short-term bond fund, but only half as much as that of a long-term fund. When it comes to income, however, the longer a bond fund's average maturity, the more stable its income stream. The reason? It takes longer for long-term bond holdings to mature, be reinvested, and reflect changes in market rates than it does for short-term holdings.
One advantage bond funds hold over individual bonds is diversification. A bond fund may hold hundreds of securities, making it less susceptible to the effects of a particular bond issuer's default on the payment of interest or principal, Unless an investor holds only U.S. Treasury bonds, which have essentially no credit risk, it's important to invest in a diversified pool of bonds. It can take hundreds of thousands of dollars to build your own bond portfolio, but only a few thousand dollars to get sucri diversification through a bond fund.

Source: "IN THE VANGUARD", Winter 2000