The Michael Shearin Group Morgan Stanley, Five Myths of Bond Investing

Are bonds a portfolio's bulwark or its Achilles' heel? Investors can't seem to decide.

Over the last seven months of 2013, amid rising interest rates and falling bond prices, skittish investors yanked $18 billion more out of bond funds than they put in.

Then, as stocks faltered in the first six weeks of 2014, investors put in over $28 billion more to bond funds than they withdrew.

Adding to the confusion: Wednesday's disclosure that Federal Reserve officials are debating whether to raise interest rates sooner than expected. The yield on the 10-year U.S. Treasury hit 2.75% on the news, up from 1.62% in May. (Bond yields move in the opposite direction of prices.)

After three decades of a mostly smooth and steady bond market, investors aren't used to the recent volatility. That could be leading some to abandon their portfolios' primary defenses right when they need them the most, experts say.

"Bonds are thought of as a safe haven, but even the safest harbors have waves," says Martin Leibowitz, a managing director of research at Morgan Stanley and co-author of "Inside the Yield Book," considered by investors to be one of the best books ever written on bonds.

Like all areas of investing, the bond market is rife with popular beliefs that are only partly true at best and misleading at worst. If you want to stop lurching from one wrong-footed bond trade to another, it pays to separate myth from reality.

Here is a guide to some of the most dangerous misinformation about investing in bonds and bond funds—along with practical steps you can take to invest wisely on the basis of more-accurate evidence.

Myth No. 1: Bond investors will suffer huge losses when interest rates rise.

Long-term U.S. Treasury bonds lost 12.7% last year as rates rose roughly one percentage point. And many Wall Street strategists expect rates to climb this year as the Fed changes course.

Yet losses on that scale across a wide variety of bonds are unlikely. To see why, you need a basic understanding of what pros call "duration."

That measure—available from your fund's website or, if you buy individual bonds, from your broker—shows the approximate percentage change in the price of a bond or bond fund for an immediate one-percentage-point move in interest rates.

The duration of the Barclays U.S. Aggregate Bond Index, the broadest benchmark for the fixed-income market, was around 5.6 years this past week. Thus, if rates rise one percentage point, the Barclays Aggregate would immediately fall in price by approximately 5.6%; a half-point rise would knock the index down in price by 2.8%, and so on.

"For big losses to occur, interest rates would have to rise enormously," says Frank Fabozzi, a bond expert who teaches finance at EDHEC Business School in Paris and Princeton University.

To incur a 20% loss on a bond fund with a duration of 5.6 years, for instance, interest rates would have to rise instantaneously by approximately four percentage points. Even a 10% loss would require an immediate—and historically unprecedented—jump in rates of roughly two points. (Long-term U.S. Treasurys have a duration of more than 16 years, which is why they are so sensitive to rising rates.)

At today's low rates, "you should have lower expectations for total return and yield, but the extent of the potential negative returns has been exaggerated," says Matthew Tucker, head of fixed-income strategy at BlackRock's iShares unit, the largest manager of exchange-traded funds.

That is because, as rates rise, you get to invest the income thrown off by your old bonds at the new, higher yields. As a bond investor, your total return is the sum of any price changes and the income the bonds produce.

Imagine that interest rates rise by a quarter of a percentage point. That would immediately knock about 1.4% off the price of a bond fund with a duration of 5.6 years. But it also would add a quarter-point to the yield of fresh bonds coming into the portfolio, making up over the longer term for the short-term decline in price.

In recently published research, Morgan Stanley's Mr. Leibowitz has shown that so long as a fund (or even a "ladder" of individual bonds assembled to mature at equally spaced intervals of time) maintains a moderate, five-to-six-year duration, the portfolio's annual total return should converge toward its original yield. That assumes that you hold the fund or ladder at least six years.

Remarkably, he found that outcome will occur under almost all possible scenarios, regardless of how much interest rates change.

As a result, Mr. Leibowitz says, "if you are determinedly a long-term investor, you can get through a period of intervening turbulence" comfortable in the knowledge that any losses in market value will be offset over time by the extra income from higher rates.

All this points toward a simple strategy: Ignore the harum-scarum rhetoric about a bond-market bloodbath. For government and investment-grade corporate bonds and bond funds with a duration less than 10 years, that scenario is just a myth.

So long as you keep your duration short—and stick with high-quality bonds—you should be in no danger of anything greater than a temporary, single-digit loss.

Ask yourself what is the worst loss you are willing to withstand on your bond investments for each one-percentage-point rise in interest rates. If that maximum loss is 5%, then you want a bond or bond fund with a duration of five years, slightly shorter than that of the Barclays Aggregate. (The average intermediate-term bond fund, according to Chicago-based investment researcher Morningstar, has a duration of 4.9 years.)

You can get higher yield than the current 2.3% offered by the Barclays Aggregate Index—but only if you are comfortable with higher duration. The Vanguard Long-Term Corporate Bond VCLT +0.39%  ETF, for instance, yields 5%, but its duration is 13.4 years—meaning that a quarter-point rise in rates would trigger a 3.4% short-term decline in price.

Myth No. 2: Investors who need income must own "bond alternatives."

These alternatives include real-estate investment trusts, master limited partnerships, preferred stock, dividend-paying common stock, business-development companies and bank loans.

"None of these things are substitutes for the safest bonds," says Larry Swedroe, director of research at the BAM Alliance, a nationwide group of investment advisers based in St. Louis. Some of these assets, like REITs and MLPs, "have good diversification characteristics and can play a role in a diversified portfolio," he says. The other popular bond alternatives, he warns, provide extra income in good times—but won't act like bonds during bad times.