Cents and Sensibility Guy Steele

There are reasons to hold bonds even when prices fall

Answer: Two factors are largely responsible for lower bond prices. First, when big gains in employment are reported, the financial markets see this as a sign of strong economic growth. Historically, stronger economic growth has typically led to higher inflation -- and higher inflation erodes the value of fixed-income investments, such as bonds. Consequently, bond prices have fallen in anticipation of rising inflation.

The second factor behind the slide in bond prices is the market's perception that the Federal Reserve will seek to combat inflation by raising interest rates. And when interest rates rise, bond prices fall. That's because existing bonds, with their lower interest rates, are less attractive to investors than newly issued bonds paying higher rates.

Clearly, bond prices fall due to economic forces -- not necessarily because there's anything "wrong" with your bonds. But that may not make you feel much better over the recent price decline. Should you sell your bonds to avoid further losses? Actually, you've got some good reasons to hold your bonds. Here are a few to consider:

» Return of principal -- When you purchase high-quality, investment-grade bonds, you can expect to receive the principal amount (called "face value") back when the bonds mature.

» Regular interest payments -- If you bought your bonds for the income, you have little reason to sell. Your interest payments will stay the same throughout the life of the bond, no matter if prices rise or fall as long as the bond issuer does not default.

» Portfolio diversification -- If you're overconcentrated in one type of financial asset, your portfolio is vulnerable to big downturns if that one asset class takes a big hit. So, if your holdings are getting too stock-heavy, you'll want some bonds to lower your risk level.

As we've seen, you can achieve significant benefits by keeping your bonds. At the same time, you don't have to be victimized by ever-changing market interest rates. Instead, you can work toward building an "all weather" portfolio by creating a "ladder" of bonds with varying maturities.

When you construct a ladder, you can take advantage of all interest-rate environments. If market rates are low, you'll still have higher-yielding, longer-term bonds working for you (be aware of possible call features, though). And when market rates rise, you can reinvest the money coming due from your short-term bonds at the higher rates. Ultimately, a well-constructed ladder can help you smooth out your bond portfolio's yield.

You don't like to see the value of any of your investments decline. But by realizing that the reasons you bought your bonds are still valid, and by diversifying your bond portfolio through a ladder, you can look beyond the seemingly bad news of your monthly statement -- and stay on track toward your important financial goals.