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Why you should be buying bonds now

(MoneyWatch) Stocks are at an all-time high, while bonds are down this year due to rising rates. Since yields on high quality bonds are so low, and economists predict that rates will continue to rise, bonds are feeling unloved. How unloved? According to the Investment Company Institute, investors have pulled $144.3 billion out of bond funds since June of this year.

So am I crazy to be selling stock funds and buying bond funds right now? Perhaps, but let me explain my logic.

First, stocks have surged and most people don’t realize by how much. If your timing was terrible and you bought $100,000 of the Vanguard Total Stock Market ETF on Oct. 9, 2007 (the pre-financial collapse high), you’d have $135,860 as of Nov. 22. This means that stocks are now 35.9 percent higher today than they were before Lehman Brothers went extinct and we believed real estate could never decline.

Second, I put no credibility in economist forecasts. A 2005 study by professors at The University of North Carolina found the top economists’ forecasts were less accurate than a random number generator.

Finally, I reject the idea that bonds are riskier than stocks. According to research by Vanguard, even if rates do rise, it would ultimately mean higher returns for investors. If, for example, rates rose by two percentage points, the results would not be that catastrophic for bonds. Using bond funds following the Barclay’s Aggregate Bond Index, such as the Vanguard Total Bond Fund (BND), a two percentage increase in rates would result in a 7.9 percent loss over a year. While bad, it pales in comparison to the two 50 percent plunges in stocks since 1999.

But even that 7.9 percent decline in the bond fund has a silver lining for those who can manage not to panic. The bond funds are laddered bond portfolios and would be reinvesting matured bonds at higher rates. If rates stabilized after this increase, total returns, including this loss, would turn positive by year three; by year seven returns would be higher than if rates hadn’t changed.

As crazy as it may appear to be buying bonds when they are floundering at a time when stocks are surging, it's all part of my rebalancing strategy. Sure, such a strategy can seem like financial masochism, like buying stocks after the financial collapse of 2008. But think of it instead like skidding on an icy road -- you have to turn in the direction of the skid in order to pull out of it. Rebalancing to one's asset allocation, whether by selling up asset classes or buying the down classes, does that for your portfolio.   

Also never forget that fixed income is the shock absorber of your portfolio. Buy high quality bonds or CDs no matter what the experts say.