Mortimer Adler (1902-2001), perhaps the greatest American philosopher of the 20th century (Time Magazine) wrote a volume in 1940 called How to Read a Book. I was introduced to this 400-page tome when I was 38 years old, and I thought, "You've got to be kidding! This book must be either silly or pretentious." I couldn't have been more wrong! Instead, this profound thinker and lifetime educator introduced me to the skill of skimming a book at several levels before deciding whether it was worth spending the time to really absorb the author's argument.

Adler also wrote books with titles beginning with the phase, "How To Think About ... ." They include How To Think About Great Ideas, How To Think About God and How To Think About War and Peace. I suppose that Dr. Adler was not much interested in the subject of bonds, for despite the fact that he continued writing past his 95th birthday, he never undertook a treatise on "How To Think About Bonds."

While I am certainly no Mortimer Adler, and although I have but a few pages in which to address this theme, my goal is similar to his. That is, to stir up in the reader a level of interest that will prompt fresh, creative thinking on an important subject. It was Adler's style to avoid technical jargon when he journeyed into a new subject, the better to engage a reader whose everyday interests may lie far afield of the topic at hand. I will endeavor to imitate him in this regard, lest you lose interest early.

More Important Than We Thought

Are bonds a worthy subject? For nearly two decades, portfolios of large-cap U.S. growth stocks enjoyed returns of more than twice the rate of interest on 10-year bonds issued by the very same corporations. And compared with the bond market slumps of 1994 and 1999, equity returns were even less volatile. Since the memory of man runneth not to the contrary, the raison d'etre of fixed-income securities has been that they provide modest but safe returns. But the experience of the 1980s and 1990s trained a whole generation of advisors to disdain these attributes.

Then the "new millennium" exploded on the scene. In 2000, stocks lost between 10% and 40%, depending on your index preference, while 30-year Treasury strips gained more than 30% in value. A fluke? Well, this year we have had another double-digit performance gap in favor of bonds. Could it be that the ancients (those trained in investing before 1982) were not completely off their rockers when they proposed bonds as a serious diversification tool?

Are We Thinking About Recent Events?

I must have read a hundred post-September 11 editorials proclaiming that, "Our lives are changed forever" or "Life in the United States will never be the same." So, when I attended a conference of several hundred personal financial advisors in late October, I was filled with anticipation of animated debates about the ways in which terrorism may ultimately influence our economy and our capital markets. Naturally, speakers and topics were selected months before, so I did not expect these questions to appear in the formal agenda. But I was disturbed that the subject did not emerge in a single presentation or private conversation for the entire first day.

On the second day of the conference, I was determined to raise the topic with as many advisors as possible. "Have you been reconsidering your long-term growth expectations for an economy that must spend heavily on homeland security?" I would ask. Or, "Have we seen the last wave of fear among investors? Do you think fear will have a long-term influence on P/E ratios?" "I wonder if an increase in government spending will be inflationary. Have you thought about that yet?" "It seems like we are heading back to government deficits, doesn't it? Do you suppose that will drive interest rates back up?" "Are you thinking of reducing your long-term investment return expectations? Or changing your asset allocation?"

The people I spoke with, folks that I know to be rational and caring advisors, pretty consistently had two reactions. First, they seemed relieved that someone had brought up the question. Second, they suggested that although these issues certainly were on their minds, they didn't really know how to think about them. Part of the difficulty, of course, is emotional; it feels crass to process our country's tragic developments in financial and economic terms.

But I believe there is another reason that advisors feel confused and unable to sort out the questions du jour. It is that they have become so accustomed to steady economic growth and heady returns from stocks that they feel defenseless when their brains start receiving signals that suggest something completely different may be afoot.

For example, have you tried to put in some kind of context the stock market decline of 2000-01? It may come as a shock to you (it did to me) that if you had invested one dollar in long-term bonds on December 31, 1996, and another dollar in large-cap stocks at the same time, they would both be worth exactly the same ($1.56) on the recent day I was writing this column. Over nearly five years, absolutely no advantage has accrued to the equity investor. Taking the risks of ownership has produced no excess return. None! Is that consistent with the worldview from which you have been offering advice?

Let's examine the equity-oriented advisor's feeling of confusion a little further. We've suffered a 22% decline in the S&P 500 in the last 12 months. Yet the P/E ratio is still a whopping 30; earnings have fallen as fast as stock prices. Well, you say, the stock market is a forecasting machine. It is looking forward to the other side of the recession when profits undoubtedly will soar to new highs. Undoubtedly?

Consider that in March 2000 the stock market was also a forecasting machine. It forecast a "new economy" with growth as far as the eye could see. What it got was a new economy, all right, but it was not the one we expected. Our new economy is one without the World Trade Center on its horizon. One in which a greater share of national resources will be swallowed up in searching suitcases and screening mail. Will we be up to the task of defending our freedoms? History suggests we have every right to be confident. But will our economic formulas be the same as during our unfettered years?

Or might the presence of a more interventionist government and the soaring cost of personal security slow our private-sector growth? Might profit margins back off from their historic highs as whole industries restructure for a different environment? Could frightened citizens be inclined to rebuild their balance sheets rather than buying bigger homes and newer cars? Could stock prices begin to discount the future more skeptically?

If you believe that the stock market correction has already made equities patently cheap, and if you also believe that the advent of domestic terrorism overlaid on a debt-bloated private sector will not diminish our economy's future growth, then you may not find it worth the time to understand the bond side of our capital markets. Otherwise, you may want to become more familiar with bonds.

Bonds For A Different Tomorrow

A case surely can be made that terrorism will soon be rendered toothless, and that life will return to its former state of innocent prosperity. Picture a world in which our alliances with oil-rich Muslim states are secure, in which the Israeli lion lies down with the PLO lamb (or vice versa if you prefer), in which the have-not dictatorships adopt our democratic free-market model. But unless you are convinced of this rosy outlook, might it not be worth at least thinking about an alternative scenario, and its implications for the sort of advice you offer, especially to your retired clients?

Suppose recent events ushers in a world where even sluggish GDP growth is not a given. What if the record profit margins of the idyllic world of 1999 are not seen again for a decade or more? Could international tensions restrict trade and end the dominance of the dollar? What sort of asset allocation would you adopt if you thought that stocks might earn little or no return for five years?

Let's say that a heightened level of uncertainty concerning future growth convinces you that a safe, up-front return is at least worthy of a place in a diversified portfolio. You look around and find that the money market yield is close to 3%. That's pretty exciting; not! Hey, we'll just go out on the yield curve and take a little more interest rate risk. So you look at 10-year noncallable Treasuries and see a not-much-better 4.6%. This is not fun. Then how about taking some credit risk? A peak at 10-year, single-A corporate bonds finds something like 6.4%. At least you won't be ashamed to bring that home to Mother. But will it keep your clients happy?

Fixed-Income Basics

Where can I find a 7% return with a level of interest rate risk and credit risk I can live with that doesn't have an early call? Before we look at a list of different kinds of income securities, here are a few fixed-income basic concepts to keep in mind.

Yield Curve: A line graph of interest rates from three months to 30 years. A normal curve rises modestly as maturity lengthens. Recently, the curve is very steep with long rates more than double the short rates.

Interest-rate risk: Publicly traded bonds change in price based on shifts in competitive interest rates. Rates fall, prices rise. Rates rise, prices fall. The more distant the maturity date, the more sensitive the price is to rate changes. Since we cannot know the future, fixed-income investors are well-advised to diversify their bond holdings across a wide range of maturities. What matters when you report to your clients is total return-interest income plus or minus the change in price.

Credit risk: A bond is evidence of a loan. A lender has a different worldview from an owner (stockholder). A bondholder has modest return expectations, but those expectations are easily shaken if a borrower's credit is impaired. Conse-quently, a bond's market price will reflect any change in the likelihood that its terms will be honored. Sometimes a credit downgrade provides a buying opportunity; other times it is a shot across the bow.

Buying-power (inflation) risk: A borrower agrees to return the face amount of the bond at a specific future date. The further in the future this maturity date is, the greater the lender's risk of receiving less valuable dollars because of the ravages of inflation. This risk needs to be contemplated in the agreed interest rate. Or buy a bond with inflation protection.

Mix Your Risks

I offer here a short list of fixed-income types, along with 25 cents worth of wisdom on each to get you started. Consider them ingredients to fold into your portfolio mix, and don't overdo any one of them. It's OK to tilt your allocation in the direction of your convictions, but diversify. Just like you do with stocks.

Treasuries: Very liquid, and extremely low credit risk, but the lowest interest rates for each maturity. Want to bet on falling interest rates? Use noncallable Treasuries because they are a pure play. Don't bother with Treasury mutual funds.

Inflation-indexed treasuries (TIPS): Worried about a rising CPI? These give you more than a 3% real return, plus a hedge against a resurgence of inflation. Best used in IRA because of tax quirks.

Corporates: Investment grade (AAA down to BBB) have the least credit risk. Corporate bond mutual funds with low costs make sense because they diversify the business risks for you. Junk bonds (BB and lower) sport double-digit yields, but defaults can wipe out your excess return in an extended recession. If you want to go for 14% yield minus whatever principal losses happen, use a fund.

Municipal bonds: To see whether a tax-free municipal bond is attractive, divide its yield to maturity by 1 minus your marginal tax rate. A 4.8% yield doesn't sound like much until you consider it is equal to an 8.7% taxable yield for some high-bracket clients! Watch out for calls and for high broker markups. Low-cost, state-specific muni funds make sense.

Preferred stock funds: A non-bond, fixed-income security paying around 7%. I like closed-end mutual funds that sell at a discount to NAV. Check whether a fund leverages its portfolio with short-term borrowed money (borrowing short and lending long enhances dividends until the yield curve starts to flatten.)

GNMA Funds: Government-backed mortgages offer maybe a 70 basis-point premium over long Treasury yields. Good if rates are stable. But if rates rise or fall much, you're better off with straight Treasuries because variation in refinancing activity plays havoc with the security prices.

Using these ingredients, even in today's reduced interest rate environment, you can create a diversified fixed-income portfolio with a yield to maturity of 6% to 7%. Considering what could happen, is that so terrible? I hope you will think about it.

J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.