Gorging on Bonds? Prepare for Upset Portfolio

Individual investors' hunger for bonds just won't let up. Through early March net cash inflows into bond funds surpassed $72 billion, compared to just $18.5 billion in net cash finding its way into stock funds. That's on the heels of a Joey Chestnut-esque appetite in 2009: investors poured about $375 billion into bond mutual funds in '09 compared to net outflows from stock funds of nearly $9 billion.

If you've been gorging on bonds you could soon be feeling the effects of an upset portfolio. While bonds are indeed intrinsically less volatile than stocks, right now fixed income is packing plenty of risk due to abnormally low interest-rates.

Coming up Short The Federal Reserve signaled mid-March that it intends to keep key interest rates "exceptionally low" because of the perceived weakness of the economic recovery. But the reality is that rates, eventually, must rise. All the Fed is saying is "not just yet."

When the rate rise does begin in earnest, watch out. the supposed "safest" part of the yield curve -- the short end -- is likely to see the biggest net losses in terms of total return. That's because the super-low yields in the short end of the yield curve will not provide much cushion against falling prices when rates start to rise. Check out the hypothetical illustrations below of how rising rates might impact different stops on the yield curve. The low current yields on short-term bonds makes them especially vulnerable for total-return investors.

Source: Vanguard

Joseph David, Vanguard's chief economist summed up the looming risk in the short-end of the bond pool: "--investors have moved into precisely the area where--if bond market expectations are correct--the poorest returns could occur."

The Fix for Income
Now that's not to suggest you should bail on bonds. But if you have been gorging on bonds since the financial crisis and your portfolio is listing too far to the bond side, now would be an especially good time to rebalance back toward your age-appropriate mix of stocks, bonds, and cash. If you're in the hunt for income, it's pretty easy to find dividend-paying stocks right now that throw off more income than short-term bonds. For example, the SPDR Dividend ETF (SDY) has a current yield of more than 3.5%, well above the payout on short-term bonds right now.

Related MoneyWatch articles:
Bond Warning: Why your Safe Investment isn't so Safe
Starved for Yield? Stock Up
Higher Yields, Safe Returns

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