BOSTON -- Baby boomers fully embraced the stock market by riding its ups and downs throughout their peak income years.
But now that the oldest boomers are turning 65, their focus has turned toward ensuring a steady income from their investments. And they're likely to find the answer is to put money in bonds rather than stocks, as recent market volatility shows.
Consider that bonds have made stock returns look puny in recent years. Broadly diversified bond mutual funds have provided investors an average annualized return of nearly 5.6 percent over the past five years. That's better than all of the domestic stock fund categories that Morningstar tracks.
With retirement just around the corner for such a sizeable population, it's understandable that investors have deposited a net $670 billion into bond mutual funds since January 2009, while consistently pulling their money out of stock funds. Fidelity Investments says its clients alone have added $100 billion in new cash to bond investments over the past three years.
But do the stock-savvy boomers and others who have flocked to fixed-income investments really understand bond investing, and the potential risks and rewards?
Many fund companies believe there's a pressing need for investors to bone up on their bond basics, so the companies are putting more resources into the investment products that have been drawing the most new cash. Fidelity upgraded its online resources for bond investors in September, and Nuveen Investments made a similar move this month.
It's a recognition that bonds are more complex than stocks, with more moving parts that influence investment returns: yield, price and interest rates, for starters.
Interest rates are perhaps the most critical risk for bond investors now. Short-term rates are near zero, and have nowhere to go but up. When they eventually rise, if the economic recovery really gets going, expect to see lower bond returns and possibly losses.
The economy is growing so slowly that interest rates aren't likely to spike in the short run. Any increase would be unwelcome for investors.
"It's a phenomenon that bond fund investors haven't faced in a very long time," says analyst Loren Fox of the fund industry consultancy Strategic Insight. "Some will be surprised and disappointed when it happens." Indeed, investors have become accustomed to declining rates for the better part of 30 years.
Below are key points investors should know about bonds, and a snapshot of the potential risks that investors face:
At the most basic level, bond investors are lending their cash to a company, in the case of corporate bonds, or to government in the case of U.S. Treasurys or municipal bonds.
In contrast, stock investors hold an ownership stake in a company, however small.
Bonds are considered safer than stocks because there's typically a low risk that the borrower won't repay the loan when it's due, or default by failing to make scheduled interest payments.
In contrast, the markets view of a company's profit prospects will vary widely over time, which makes stock prices volatile.
Bonds pay fixed returns. The yield is the amount an investor receives for holding a bond until the date when it matures, or principal is repaid, expressed as a percentage.
Interest is paid regularly to investors through coupon payments. The coupon is the annual rate of interest divided by the purchase price, meaning a bond selling for $1,000 with a 5 percent coupon rate offers a 5 percent current yield.
Unless a bond is held to maturity, the return investors receive is also a function of price changes. For example, that bond that yielded 5 percent at a price of $1,000 would yield 10 percent at a price of just $500. As a bond's price falls, its yield rises, and vice versa.
Prices change because investors continually process new information about the risks they face from factors such as interest rates, inflation and credit risks -- the potential for a default.
If investors can buy newly issued bonds paying higher interest than previously issued bonds, the value of the older bonds declines. On the flip side, an older bond will rise in price if yields for newly issued bonds are lower.
Individual bonds vs. funds
Investing in individual bonds offers some certainty if the investor holds them until maturity. Investors receive pre-determined interest payments along with repayment of principal, provided the company or government issuing the bond makes good on its obligations.
But it's not easy for an individual investor to research whether a bond is attractively priced relative to its credit risks and other potential pitfalls.
Investing in a bond mutual fund, rather than an individual bond, means an investor faces less risk from the possibility of a default. Bond funds typically hold diversified portfolios of hundreds of bonds. If just a single bond defaults, the impact on the overall portfolio is likely to be modest. However, a fund's returns will vary because the fund manager must continually reinvest as bonds mature.
Because bond prices fluctuate, it's possible for mutual funds to lose money. That can happen when the fund generates less interest income than going market rates for newly issued bonds. And investing in a bond fund means paying fees for professional expertise.
What's more, there's no certainty that expertise will generate returns superior to those investors could get on their own, or by investing in a low-cost bond index fund.
Bond investors now face substantial long-term risk from rising interest rates. When the Federal Reserve raises rates, returns for different types of bonds will be affected differently depending on factors such as their maturity dates.
For example, one reason that 30-year Treasurys offer a higher return than T-bills maturing in a few months is that there's a greater chance that rates will rise over the long haul, hurting returns. Longer-duration bonds pay investors more to offset that risk.
Inflation is also low, and the eventual likelihood of rising prices poses risks for bond investors, similar to interest rate risks. However, certain types of bonds offer protection. The best known are Treasury Inflation-Protected Securities, or TIPS, a type of Treasury bond whose payout is adjusted every six months for inflation.