The Motley Fool: Yes, bonds can go down

Many people assume that while stocks can drop in value, bonds won’t. Yet there’s a big correction going on in fixed income, especially long-term bonds.

You may think of bonds as a way to stabilize some of the fluctuations in your portfolio. But with yields soaring, you should be prepared for some sizable losses on your bond holdings when your next statements arrive. (As general interest rates rise, prices of existing bonds tend to fall, as there are suddenly more attractive, newer bonds available.)

Long-term bond prices have fallen 8 percent to 10 percent since December, when investors were convinced that rate cuts from the Federal Reserve were imminent. Now, many market commentators are suggesting that the Fed may soon hike rates.

All of this is just more bad news for interest-sensitive sectors of the economy, such as mortgage lending and real estate. With the subprime lending crisis having forced lenders to tighten their credit standards, rising mortgage rates will price some potential buyers out of a home purchase, even if they have good credit. This in turn could force sellers to lower asking prices to make them more affordable for prospective buyers, exacerbating recent price declines.

Rising rates are a nightmare for homebuilders, which could face not only lower demand but also higher carrying costs for their inventory.

For investors with bond-heavy portfolios, especially retirees on limited incomes, falling bond prices may translate into considerable pain. It’s a good reminder, however, that even the most conservative portfolios can benefit from diversification. Even if you need current income, bonds aren’t the only way to get it. Dividend-paying stocks and real estate investment trusts (REITs) are just a couple of the alternatives that provide steady income without the same level of interest-rate risk that bonds have.

If falling bond prices have you flustered, you may need a retirement portfolio overhaul. Our Rule Your Retirement newsletter offers great tips on how to allocate your assets across a variety of investments to protect against big drops in any one class. Try the service for free at www.fool.com/shop/newsletters.

Ask the Fool

Q: Can you explain what arbitrage is? — S.S., San Antonio

A: Arbitrage is the practice of profiting from short-term differences in price. Imagine that in the United States, for $20 per share, you can buy stock in Rubber Chicken Catering Co. (ticker: CHEWY). Meanwhile, you see that it’s currently selling for $20.50 per share in England. If you simultaneously buy shares in America and sell the same number of shares in England, you’ve earned a profit of 50 cents per share (not counting commission costs). This may not seem like much, but those who practice arbitrage are usually large institutional investors with millions to invest in big positions.

Q: What, exactly, does a company’s chief financial officer do? — L.B., Biloxi, Miss.

A: A company’s chief financial officer (CFO), such as Southwest Airlines’ Laura Wright, Home Depot’s Carol Tomé, and Verizon Communications’ Doreen Toben, is responsible for all things financial at the firm. These include determining what its financial needs are and will be, deciding how best to finance those needs, and informing all stakeholders (investors, creditors, analysts, employees and management) of the firm’s financial condition.

The CFO is also focused on creating and maintaining the best mix of internal cash, debt financing and equity financing for the company (this is known as a firm’s “capital structure”). As part of those responsibilities, the CFO plans and oversees the forecasting and budgeting process, maintains relationships with funding sources such as commercial and investment banks, and oversees the process of developing and communicating the quarterly and annual financial statements.

My dumbest investment

My dumbest investment? That’s easy — a penny stock in the energy business. I received an e-mail promoting it that looked reliable, only to find out later that it was spam. $746 in, $1 out. But that’s how we live and learn. — J.W.,Montgomery, Ala.

The Fool Responds: Many of our best-learned lessons are learned the hard way. And at least you only lost hundreds, not thousands or much more, like many others.

It’s usually not even worth it to “take a chance” on penny stocks (those trading for less than $5 per share).

According to Consumer Reports Money Advisor, one fellow “bought” (for a mock portfolio only) 1,000 shares of every penny stock touted in spam e-mail he received over two years. After “investing” nearly $58,000 in 68 stocks, he lost 84 percent, ending up with $9,025. Only four of the 68 stocks showed a gain!