Investing: What can happen if the bond bull goes bust?

— -- Before you do something risky, like wolf wrestling, it's always best to ask yourself what the worst possible outcome might be.

One way is to have someone else try it first — preferably your neighbor.

Failing that, you can look and see what happened in similar situations in the past. Although you might not realize it, bond funds are riding a 30-year bull market. What's the worst that can happen if the bond bull goes bust? We actually have a pretty good idea.

First, you need to know this about bonds: They do very well when interest rates fall — and very poorly when interest rates rise.

Bond yields have been falling since Sept. 30, 1981, when the 10-year Treasury note hit its all-time high yield of 15.84%. It now yields 1.98% and last week hit a record low 1.73%.

As you can imagine, bond funds have been great investments from September 1981 through the end of last month. How two long-lived bond funds fared:

•Franklin U.S. Government Securities fund gained 1,151%, a 8.81% average annual return, says Lipper, which tracks the funds.

•Putnam Income, a general-purpose bond fund, gained 1,274%, or an average annual 9.15% return.

Returns like that — especially in light of the miserable stock market of the past decade — have caught investors' fancy in a big way. Investors have poured about $143 billion into taxable bond funds the past 12 months, says the Investment Company Institute.

At 1.98%, it's hard to imagine the 10-year T-note yield falling much further. What's the worst that could happen if rates rise?

We can get some idea from the wretched 1970s. The yield on the 10-year T-note soared from 5.5% in March 1971 to 15.7% in September 1981. During that period, Franklin U.S. Government gained 7.5%, or an average annual return of 0.69%. Putnam gained 47%, averaging a 3.74% return a year.

For a multiyear bear market, these are not horrific returns. (Bear in mind, however, that inflation averaged 8.4% a year during that period.)

A bond bear market beginning at current levels could be more severe than the 1970s version. Back then, your total return included hefty interest payments, which cushioned price declines.

At 1.98%, however, you're getting about as much cushion as a mouse pad. And price declines could be severe. Let's say you own the current 10-year T-note, which pays $215 interest for every $10,000 in face value.

Let's say, further, that rates on similar investments have risen to 3%. You decide to sell your bond. But there's a problem: Bond traders will sneer at a bond that yields 2.125%.

You'll have to cut the sales price of your bond. In this case, you'd cut it to $9,250, a 7.5% haircut.

The higher interest rates go, the more you'll have to slash your bond's price. If rates go to 6.5% — roughly the average rate for the past 40 years — your bond would sell for $6,820, a 32% loss. At 15%: $3,430.70.

If you hang on to your bond, you'll get its full face value when it matures, and you can ignore the taunts of other bondholders.

Bond funds, however, have to value their holdings every day to figure out their share price. When rates rise, the fund's share price will fall, even if the fund doesn't sell its bond.

It's unlikely that interest rates will rise soon: The economy is just too weak, and the Federal Reserve is buying longer-term bonds to keep rates low. If they do, however, you're going to need to change your bond strategy. A few choices: