With interest rates starting to rise, is now the wrong time to invest in bond funds?

Question: I have about $400,000 in a 401(k), 95% of it in stocks. I want to move toward a position with 25% in bonds. My 401(k) offers one bond fund, Fidelity U.S. Bond Index fund. Is this a good time to move into bond funds with interest rates low? I've read that if interest rates start to move up (and I think they will), a bond fund will turn into a loser. Is this true, and if so, why?

— Anonymous


Answer: It's true. When interest rates rise, bond and bond-fund prices go down. And since interest rates appear to have bottomed out late last year and are headed upward, this year's forecast for the general bond market is cloudy. But if you're looking to balance out your 401(k), this news shouldn't stop you from picking up a bond fund or two.

First, you'll need a primer on how bonds and the bond markets behave. You should also take a look at the advantages and disadvantages of bond funds as opposed to individual bonds.

Now back to your question of timing. If interest rates rise this year, bond prices will go down.

But why? A bond pays a fixed rate of interest, known as the coupon rate. If other interest rates are generally rising, that coupon rate becomes relatively less attractive. At the same time, rising interest rates are usually accompanied by higher inflation, which also erodes the value of the income produced by a bond. So higher interest and inflation rates make investors less willing to buy bonds, which drives their prices down. Conversely — and perversely, it often seems to outsiders — bond investors like economic downturns because they anticipate lower rates of interest and less inflation, making the bonds they currently hold more attractive.

So, for example, while 2001 was a terrible year for the stock market, it was a stellar one for the bond market: U.S. bond funds produced double-digit returns on average, according to Andrew Clark, a senior research analyst at Lipper. But starting in November, as signs emerged that the economy might recover sooner than expected, bond investors began worrying about higher interest rates and inflation, and bond prices headed down.

It's also important to know that the bond markets look well into the future, says Clark. Because a bond can lock up your money for many years, bond investors are vitally concerned about the long-term outlook for the economy and inflation.

So what does all this mean for would-be bond investors? Interest rates may not be going lower any time soon, says Scott Berry, a bond analyst at Morningstar, but they aren't going to go much higher, either. And remember that bonds produce income in the form of interest payments. Most bond funds will still cough up income — or yield — averaging 5% to 7%, he says.

And the experience of 2001 — when bonds posted robust gains even as stocks languished for a second straight year — should serve as an object lesson in the value of diversifying your portfolio with a slug of fixed income. If you have a 20- or 30-year investment time horizon, you shouldn't be too concerned about how bonds will perform over the next 12 months, Clark says. A good diversified bond fund, like the Fidelity U.S. Bond Index fund (FBIDX) you mention, would be an excellent option. The fund tracks the Lehman Brothers Aggregate Bond index (sort of the S&P 500 Index of the bond market) and has a low expense ratio of 0.31%.

If you're investing for a shorter term, however, you might want to look at some bond funds that won't be so heavily influenced by interest-rate movement. The funds that are most affected by changing interest rates are those that hold Treasury, municipal and government-agency bonds, and these probably won't have great returns this year. Instead, you might want to look for funds that hold high-quality corporate bonds. Bonds issued by corporations tend to respond well in an improving economy since better times mean better corporate profits, which in turn make it easier for companies to meet their obligations to bondholders. Just remember that these are the riskiest class of bonds; companies, after all, can and do go bankrupt — something that governments rarely do.