Fun is a relative term. For most investors, having “fun” in 2001 mostly meant not losing their shirts. Bond owners had a good deal more fun in 2001 than the owners of stocks. However, it would be a mistake to assume that bond aficionados are having the last laugh. Bonds, like all investment types have both good and bad characteristics, and gentlemen who prefer bonds may find their long-term returns coming up short if they fail to diversify.

First, let’s define terms. When investors generically talk about bonds, they are encompassing a wide array of debt securities, all involving lending one’s money to a state or the federal government, or a corporation for a set period of time, while receiving a set payment of periodic interest. The period of time may vary from as short as a day to as long as 30 years or more. In the 19th century, some railroad bonds extended for 90 years. A debt security that matures in less than one year is considered a “cash equivalent,” or short-term bond. A debt security that matures in one to 10 years is generally considered intermediate-term, and one that matures in 10 to 30 years is considered long term.

One of the most attractive aspects of bond ownership is the interest income paid to bond holders, generally at six-month intervals. Various factors determine the interest rate at issue, including the length of maturity, the financial stability of the issuer and general economic conditions at the time of issue. For example, a corporation with shaky financials issuing long-term debt will need to offer a much higher interest payment than a short term U.S. Treasury issue to attract a buyer. The tax treatment of the bond also affects the interest paid. Interest received on bonds issued by states, counties, special districts, cities, towns, school districts, and other state and municipal facilities is generally not taxable by the federal government, and is sometimes free from state tax as well. Understandably, tax-free “munis” enjoy immense popularity among investors in high tax brackets. Thus, the issuing municipality can attract plenty of buyers at a lower interest rate than that of a corporation issuing a fully taxable bond.

Because bonds will deliver a set interest payment every six months until maturity, it is easy to plan your annual income stream from these stalwart providers. Debt securities of intermediate and long-term maturities generally offer a higher current income than the typical bank savings account, and substantially more income than the average stock dividend. Right now, a five-year U.S. Treasury note pays around 4.5 percent, while a 90-day Treasury Bill pays about 1.7 percent, and the average dividend for the S&P 500 is 1.3 percent. No wonder bonds have become the hit of the party. However, before you allow Dr. Jekyl to give you a ride home, be forewarned that Mr. Hyde has been known to make an occasional appearance in even the best-managed bond portfolio.

Bonds, like all investment securities, have risk. Bonds are essentially a promise to repay a loan with interest, but sometimes corporations and occasionally municipalities default and fail to repay. This is an unusual occurrence among debt rated “investment grade” (BBB or better by S&P), but even an investment downgrade by one of the rating services such as Moody’s or Standard & Poor’s can cause a tumble in the price of a bond. Sometimes an investment downgrade can precipitate default provisions in bond contracts resulting in a call to make good on the principal amount of the bond. We saw this recently occur in the Enron debacle. A more common reason bonds can deliver negative returns is interest rate risk. Interest rate risk is best described by example.

Suppose Jill buys at issue a 30-year $10,000 U.S. Treasury bond paying a 5.5 percent interest rate. A year later inflation has kicked in and the prevailing rate for the issuance of a similar bond is 7 percent. Should Jill wish to sell her bond to a new owner, she will have to settle for substantially less than $10,000 because who will want to buy a bond that only pays $550 per year when they can purchase a similar one that will pay $700 per year? No one will. Conversely, if rates trend down, the value of bonds rise. So, Jill’s 5.5 percent bond will look pretty good if the market is only paying 4 percent, and she’ll likely receive more than $10,000 if she decides to sell the bond. This is why bond prices are said to have an “inverse relationship” with interest rates.

Despite their shortcomings, bonds do have an important place in many portfolios. Eighteen months ago, we found ourselves working hard to convince some retired clients that bonds had a place in their portfolios. We acceded that it was true that stocks have delivered long-term total returns in the 10 to 11 percent range while bond returns have ranged from 4.5 percent to 5.5 percent depending upon whether the class measured was comprised of government or corporate securities or short to long-term maturities. Still, studies have shown that diversifying a stock portfolio with bonds significantly dampens the volatility of the overall portfolio, and that can be a boon in difficult equity markets.

This is especially true if an investor is taking annual cash withdrawals from a portfolio. It is painful to liquidate fallen securities to meet an annual income need. However, if an investor is taking an annual draw of 3 percent to 5 percent from a portfolio, and more than half is satisfied by interest and dividends, that investor can force a little smile in a down market and exercise easier patience awaiting a market recovery.

There is no one-decision investment, no panacea in a difficult market. Like stocks, bonds have virtues and vices. Unfortunately, in the aftermath of Sept. 11, many inexperienced investors ran to bonds only to purchase them at very high prices, which have now dropped with the rebound in interest rates. This is especially sad if those same investors withdrew from equities, which have recovered considerably in the last few months. Is it true bonds have more fun? Sometimes they do, but every belle has a turn at the ball, and sometimes it makes sense to dance with several partners.

Jean M. Deighan is president of Deighan Associates Inc., a SEC registered investment adviser located in Bangor.