The Boston Globe

Once-boring bonds are now so hot investors have poured
more than $70 billion into bond funds this year, and
even that wild and crazy guy, actor Steve Martin, does
a routine about them:

Looking for cover after his stocks took a beating yet
still wanting to avoid the dullness of bonds, Martin
says he turned to his financial adviser, who
recommended diversifying into fixed-income securities.

"I was like, fixed-income securities, great. Just so I
don't have to buy any bonds," says Martin, in a radio
advertisement for Merrill Lynch, where he has an

But then the adviser told Martin "bonds and
fixed-income securities are pretty much the same

The punchline? "If you're embarrassed, just call them
fixed- income securities. It's way more impressive,"
says Martin.

But seriously, buying bonds isn't something that
should be done lightly, especially when they've been
so hot.

Remember the once-hot technology sector, and the
countless late- to-the-party investors who got hurt
when the bubble burst?

Listen to these down-to-earth words from Ian
MacKinnon, managing director for the Vanguard
fixed-income group, posted on the mutual fund family's
Web site this month:"Investors who chased technology
stocks for performance reasons two years ago found out
how suddenly things can change. Overweighting in bonds
now just because they have recently performed better
overall than stocks would also be a mistake," he says
in an article titled "Vanguard Views: Beware of
Chasing Bond Performance."

MacKinnon's comments are particularly notable because
he points out that while the Vanguard GNMA fund (which
invests in mortgage- backed fixed-income securities)
has "attracted extraordinary attention" with its
year-to-date 9 percent return, "now may not be the
best time" to jump whole-hog into that sector.

But human behavior being what it is, it appears some
investors may be doing just that, chasing bond
performance, according to mutual fund data from
Strategic Insight, a New York-based research firm. As
of September, investors had put more than $70 billion
in new money in 2001 into bond mutual funds, outpacing
the $50 billion net cash inflow into stock mutual
funds, according to Strategic Insight.

So what are some of the factors to consider before
jumping into bonds or bond mutual funds?

Know the interest-rate risk. Bond prices go up in an
environment of declining interest rates, because
investors are willing to pay more for a previously
issued bond yielding a higher interest rate. That's
why bond funds have done so well this year, with the
Federal Reserve lowering interest rates 10 times.

But once interest rates start going up again, prices
will go down on previously issued bonds yielding a
lower rate, because fewer investors want to buy them.
That's why bond funds generally had negative overall
returns in 1994 and 1999, the last two years of steady
interest rate increases by the Federal Reserve.

There are ways to moderate the interest-rate risk,
however. You can buy short-term or intermediate-term
bond funds, which aren't as sensitive as long-term
bond funds to interest-rate fluctuations. Or you can
buy an individual bond and hold it to maturity, but
that can leave you stuck with a lower yield if
interest rates rise in the interim.

Know the default risk. Because bonds represent an IOU
with a company, municipality or other entity promising
to pay you interest for borrowing your money, the
financial health of the bond issuer matters. Look for
investment-grade bonds, for which the good credit of
the issuer minimizes the risk of default. And
understand that if you buy high-yield bonds, the
issuer may be paying the higher rate for a reason - to
attract investors who might otherwise stay away from
its poor credit and greater risk of default.

Know your asset allocation. Don't jump into bonds
because that's the latest hot-performing sector, or
because you've been burned by your tech stocks and
want to run to something "safe." Buy some because you
need diversification in your portfolio to offset the
volatility that inevitably comes with stocks.

So whether you call them fixed-income securities, like
Steve Martin does, or just boring old bonds, remember
that the key reason to invest in them long-term "is to
stay balanced," as Vanguard's MacKinnon says.

The tax law signed this summer by President Bush means
a boost to 401(k)s and similar tax-qualified
retirement plans. But one hitch could pose problems
for employers and taxpayers in Massachusetts and about
20 other states, according to Andrew C. Liazos,
director of law firm McDermott, Will & Emery's
executive benefits practice group.

That's because those states tie their tax code to the
federal code as of a certain date and have not yet
adopted changes to come into conformity with the new
US law.

So even if the new federal tax code allows the maximum
401(k) contribution to increase from $10,500 this year
to $11,000 next year, state laws may not yet recognize
that by the time 2002 rolls around.

In that situation, Liazos said, taxpayers may have to
pay state taxes on some of their 401(k) contribution,
or the plans' so-called tax-qualified status could be
jeopardized, unless state tax codes come into

Such compliance could be costly. Liazos pointed to
California, where lawmakers appear likely to approve
conformity legislation that is estimated to reduce
state revenues by $85 million, even as the state faces
a budget deficit in the billions of dollars.

But state compliance could also become moot if enough
time passes.

For example, so-called 529 plans for tax-favored
college education savings were first established under
federal law a number of years ago, but Massachusetts
never did pass legislation to catch up with the US
code and exempt income earned in those plans from
state tax.

However, the new law signed by Bush makes such plan
earnings free from federal taxes beginning in 2002,
and that means, in effect, that Massachusetts
residents won't have to pay state taxes on that income
either. This is because the state tax return uses
federal figures for gross income and adjusted gross
income, which will exclude 529-plan earnings.