Why Bond Investors Have Plenty to Worry About

Another factor is that yields are already rock-bottom. A 10-year Treasury purchased for its "low risk" at the nadir of the stock market meltdown in March 2009 is now up about 20 percent, while interest rates have fallen to generational lows.

To repeat this outsize performance, yields would have to fall into negative territory. Holding onto bonds until maturity might mean a real return, after inflation, of zero or below.

Right now, high-quality, long-term corporate bonds (those with top credit ratings) are paying 3 to 4 percent annually. This seems good compared with short-term bonds paying 1 percent. But if interest rates rise just 2 or 3 percentage points — which could easily happen if inflation spikes — corporate bond portfolios could dip in value more than 25 percent. Those who hold on to these bonds until maturity would break even, assuming that the issuing company doesn't go out of business. In terms of purchasing power however, these investors could still lose out because of inflation.

Investors have been snapping up higher-risk corporate bonds and this demand has lowered risk premiums — the additional yield that investors normally demand for taking on more risk. As a result, investors are taking more risk for less potential gain, and high-yield bonds are more likely to default in bad times.

How can you protect yourself? Consider these steps:

• Go short or don't go at all. Regarding the bonds you do purchase, keep durations low — a year or two at most. This way you are exposed to less risk versus long- term bonds.

• Reduce your bond exposure. Don't wait for the music to stop take action ahead of the crowd. Baron Rothschild once said, "I made my fortune by selling too early." The exact timing of a bubble bursting is hard to pinpoint but it is always better to be early than late. Besides, bonds unlike stocks, are truncated in their gains in terms of price appreciation.

• When setting your investment goals the primary goal should be to maintain your purchasing power. To achieve success you may have to set your investment goals higher than originally planned as inflation accelerates. Many investors make the mistake of using a long-term average assumption which may not be suitable in today's environment.

If you decide how much of your assets to put into bonds based on historical returns of the bond market over the past 30 years, you could end up being sorely disappointed. This may be like using an assumed 8-9 percent return for equities in 2000.

The last bear market in bonds lasted 40-plus years. In the past, these types of actions have led to a long-term increase in inflation. Keep a close eye on your wallet.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

Craig J. Coletta has 20 years of experience in the financial industry. He is president of C.J. Coletta & Co., a Registered Investment Advisor firm, and president of Coletta Investment Research Inc. Coletta is a Chartered Financial Analyst charterholder, a Chartered Market Technician and a Certified Hedge Fund Professional. He holds a B.S. in accounting and business administration from Rider University, and is a member of the American Institute of Certified Public Accountants.

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