A word of caution about bonds

Got bonds? Probably.

Many investors high-tailed it out of stocks after the market's downward spiral in 2008, searching for a safer place for their money. With dismal interest rates on savings accounts and other cash vehicles, they turned to bonds.

Investors took $18 billion out of stock funds through August of this year and piled $216 billion into bond funds, according to data from the Investment Company Institute. Although stocks had their best September since 1939, estimates through Sept. 29 show that investors ignored equities, tuned out the talk about a possible bond bubble and proceeded to pump $27.2 billion more into bonds.

Yet investment pros are lining up to say that bonds are not the place to be.

"Some investors don't see the risks associated with bond funds," said Andrew Turner, a principal with the investment management firm Riverbridge Partners in Minneapolis. The list is a mile long -- from the risk that inflation will eat up your returns to the risk that the bond issuer will default and you'll lose your investment.

He's worried that as investors stretch for yield, or return, they ignore the risk that money can be lost in bond investing, too.

How do you know if you're in a riskier bond fund?

Duration is calculated by a complex mathematical formula that you don't want me to get into here. But a rule of thumb to keep in mind is that when interest rates rise by 1 percentage point, the bond fund's value will decrease by the duration. Using Turner's example, if interest rates rise by 1 percentage point, a bond fund with a duration of eight would see its value drop by 8 percent. You can check your bond fund's duration in the prospectus or on a site such as Morningstar.com.

Of course duration can work in your favor too, with values rising when interest rates drop. But since interest rates are already so low, many analysts are predicting there's only one way they'll go. Up.

Then remember the common wisdom that investments tend to reward those willing to take higher risks with higher returns. So if you've been bragging to your neighbor about your double-digit bond fund returns, you may want to take a closer look at how much money you have in that fund and what purpose that money serves. That wouldn't be a place for your emergency savings or your son's second semester tuition payment.

"If somebody needs cash they shouldn't invest in other things," said wealth adviser Margaret Towle, who recently opened the Minneapolis office for Greycourt, an advisory firm for high net worth families and endowments. But for clients looking for an alternative to cash and bonds, she considers PIMCO's All Asset Fund (PASDX), an actively managed fund of funds with the goal of beating the consumer price index by 5 percent (its year-to-date return is 13.5 percent). Towle also likes short-duration municipal bond funds.

Turner's team at Riverbridge, which advises individual and institutional clients, currently favors shorter term bonds that mature in five or fewer years. You're not paid enough to lock money up long-term, especially when you consider the better opportunity you'll have to reinvest those dollars if rates rise.

Thomas Hull, chief investment officer for Lowry Hill Investments in Minneapolis, sees no potential in bonds unless you believe we're heading into a deflationary period, when prices fall. So he is directing clients who need income into dividend-paying stocks from high-quality U.S. companies.

"People have short-shrifted dividends for years. The whole story on stock returns was so dependent on appreciation, but we didn't see any appreciation over the last 10 years," he said.

Today, investors want yield, and companies, sitting on piles of cash, are responding. Both Target Corp. and UnitedHealth Group raised dividends this year. Cisco announced a dividend for the first time.

Once companies pay dividends, shareholders expect them to keep paying, and to increase them over time.