How Investors Can Bond With Bonds

Bonds were hit by huge losses in 1994, but analysts expect a better return this year

IN 1994 the United States bond market registered its worst losses since the Great Depression of the 1930s, as higher interest rates pummeled the value of existing fixed instruments.

But Sheryl Durham is far from fretting. Ms. Durham, manager of the bond portfolio at investment-bank Glenmede Trust Company, in Philadelphia, is convinced that 1995 will be ''a better year for bonds,'' as the US economy gradually slows and inflationary pressures are brought under control.

Durham manages bond accounts with some $2 billion in assets. While one of her three bond funds was down last year, two posted earnings gains. Durham's approach: Bond-fund investors should take a relatively-conservative stance that seeks to avoid risk, but recognizes the value of bonds as a hedge against gyrations in the stock market.

''Every person should have some bonds,'' she says. The exact amount, and the type, will vary with individuals.

''The 1980s and early 1990s were years of above-average returns on stocks,'' says Arnold Kaufman, editor of Standard & Poor's ''Outlook,'' a market report. ''But we now expect a few years of below average returns on stocks. So holding some bonds, such as three-to-five year Treasury notes, which are paying above 7 percent, looks pretty good.''

While a stock represents an ownership position in a company -- that is, the stockholder owns a ''share'' of the firm -- the bond represents a loan. The bond is an IOU. The bondholder has lent money to the company, or government, which in turn has promised to repay the bondholder a set dollar amount of interest over a precise period of time. At the end of this ''maturity'' period, the principal will be repaid.

Bond prices and interest rates move in inverse relation to each other. Say the interest rate on an outstanding bond is 6 percent. Then interest rates drop and new bonds offer only 5 percent. The higher interest rate makes the old bond more valuable. An investor would need to buy a bigger new bond to get the same amount of interest income available from an old bond. So if that old bond is sold earlier than at maturity, the seller could expect a higher price.

But what if interest rates start to rise, as happened last year? Bond holders then could get a better return by buying a new bond. So the value, the price, of the old bond drops.

A peril for all bondholders is unanticipated inflation eroding the value of their principal.

Here are some commonly asked questions about bonds:

Why own a bond at all?

Two reasons, say experts. First, the bond carries a set rate of interest. Though the price of a bond may vary with interest rates, the bondholder can be sure of his interest income. By contrast, a stock may tumble sharply in value, reflecting market gyrations. And dividend income from a stock is usually much less than the interest income on a bond. Second, there is a certain degree of safety of principal and interest. The US government stands behind Treasury issues, guaranteeing interest and repayment of principal. Corporate bonds, while carrying no such iron-clad guarantee, are almost always repaid.

How can I get into the bond market?

Your company investment plan may offer bond purchases, usually through a mutual fund. Or you can buy bonds through brokers or indirectly through shares in a bond mutual fund.

What are the main categories of bonds?

US government issues; state and local bonds, often called municipal bonds; corporate bonds, issued by corporations; and junk bonds, which are corporate bonds of a higher-risk, issued by companies that often carry a large debt load.

Will I make a high rate of total return from bonds over time?

That's the challenge. According to studies by investment research firm Ibbotson Associates Inc., Chicago, stocks consistently outperform bonds over long periods of time. On the other hand, stock markets can crash, as happened in 1929 and 1987. But bonds will still be chugging along, paying out interest. (A bond's total return is the combination of interest plus price changes.)

How can I best enter the bond market?

''If you are investing less than, say, $100,000, you would probably do best by buying quality bond mutual funds,'' says Conrad. But even bond funds can have bad years, as happened in 1994.

What if I want to buy individual bonds?

One approach: Set up a ''bond ladder,'' says Durham. This is a plan whereby you split up a bundle of money and buy numerous bonds with different interest rates and progressively longer-maturity periods. This diversity provides some protection against interest-rate fluctuations along with an interest-rate average that could be higher than that offered by a relatively secure short-term bond portfolio.

Experts stress that if you buy corporate bonds, look for bonds with high ratings from a reputable bond-rating firm. Don't overlook tax considerations. US Treasury issues are exempt from state and local income taxes; municipal issues are exempt from federal income taxes and some state and local taxes.

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Intermediate Bonds Better Than Long Bonds

The theory of greater returns for greater risk says investors should get higher returns for holding long bonds (US Treasury bonds with maturities of more than five years) than for holding intermediate bonds (one to five year maturity). But a study of the last 10, 20, and 68 years shows the total return of US Treasury long bonds is only slightly higher than for intermediate bonds.

1984-1994 Returns

Long 14.4%

Intermediate 11.4

1974-1994

Long 10.1

Intermediate 9.8

1946-1994

Long 5.0

Intermediate 5.3

Source: Jones & Babson Mutual Funds,

Ibbotson Associates