Investing Wisely

Hit a home run with bonds

Great opportunities exist, but be choosy.

By Michael Parrish

If you don't already have a sizable chunk of your portfolio in bonds, there's no time like the present to jump in.

"Every portfolio benefits from a diversified selection of bonds," says Marilyn Cohen, CEO of Envision Capital Management in Los Angeles, and author of The Bond Bible (Prentice Hall Press, 2000). "Bonds provide yin when your stocks are in a state of yang. Bonds balance your portfolio when other investments get out of whack; they also help you prepare for future financial goals."

Bonds can provide stability in rocky times, a predictable income stream, and decent—though seldom spectacular—investment returns. Over the past 75 years, the large-cap stocks of the Standard & Poor's 500 Stock Index have returned an annualized average of 11 percent. In the same period, a 60-40 mix of stocks and bonds, respectively, grew at an annualized average of 8.7 percent—still a solid return, and with considerably less volatility and risk.

Lately, moreover, bonds have had a great run as stocks have suffered. In 2000, while the average US domestic stock fund fell 0.1 percent, and tech funds avalanched by 32.6 percent, the average taxable bond fund gained 6.1 percent. The spread could grow even larger this year, given the Federal Reserve's steady lowering of interest rates. Since bond prices typically rise when interest rates fall, they'll continue upward if we have any future rate cuts.

Thanks to the Internet, bonds have never been easier or cheaper to buy. You can purchase Treasuries online, with no middleman or broker, at TreasuryDirect (www.treasurydirect.gov ). Or, if you're interested in a variety of bond types, check out private online brokers such as E*Trade (www.etrade.com ) or CSFBdirect (www.csfbdirect.com). You'll pay a low, flat-rate commission for trading in any bond category, from Treasuries to corporates.

You'll hardly be alone; bonds are likely to stay in favor with investors, particularly in these turbulent times. While big money was made in bonds in the late 1980s, and stocks were king in the 1990s, "the next decade isn't going to be either/or," says Cohen. "It will be a stock and bond market."

The investment environment for bonds changes constantly, and it's too soon to tell what the long-term impact of the terrorist attacks will be on the bond market. Some bond categories have already had their best run in this cycle. "At some point, we're going to have a stock market recovery, and it will inevitably take the glow off some bonds," says Cohen.

"I don't think bonds can rally much more," agrees Kirk D. Hartman, managing director of fixed-income securities at Banc of America Capital Management, the nation's largest private bank. "I'd get in carefully now. Until we see what's going to happen with the economy, I'd look at funds with short-term maturities or highly rated corporate bonds. I wouldn't buy 10-, 20-, or 30-year bonds right now."

Meanwhile, many of today's bonds have such complex features, and can be so volatile, that investors have to keep track of their bonds just as they do their stocks. Most government bonds are as safe and predictable as always. But other types of bond are no longer Steady Eddie investments.

Here's what to look for as you navigate the bond market.

Government bonds: Safety but plodding returns

Treasuries are backed by the "full faith and credit" of the federal government, and are the lowest-risk securities you can buy. (For a ton of online information on these securities, check outwww.publicdebt.treas.gov). T-bills, which mature in a year or less, are often considered the safest of all fixed-income investments because, in such a short time, you run little risk of a substantial interest rate change—and the potential loss of bond price. Treasury notes have maturities ranging from two years to 10.

At the other end of the spectrum, 30-year Treasury bonds generally give the best return of all Treasuries precisely because they face greater risk from interest rate moves in the market over a longer period. In early October, for instance, a three-month T-bill yielded 2.2 percent; a five-year Treasury note, 3.8 percent; and a 30-year bond, 5.4 percent.

For that reason, says Cohen, stick to the middle ground in Treasuries. Treasury notes that mature in seven to 10 years usually provide relatively high returns but with much less volatility and interest-rate risk than a 30-year bond.

If extreme safety is your goal, go with so-called TIPS—Treasury inflation-protected securities (officially known as Treasury inflation-indexed securities). Their yield is adjusted to keep pace with inflation. Conventional Treasuries risk losing value to a rise in the inflation rate. TIPS have a lower yield, but aren't exposed to that risk because the bond's principal value is adjusted by the government to compensate for changes in market interest rates. You're guaranteed to receive, on a pre-tax basis, a known real return above inflation. In early October, a 10-year TIPS was yielding 3.1 percent. (Current TIPS yields are available at www.bloomberg.com .)

"I absolutely love them—they're a great insurance policy," says Cohen, who recommends that they constitute 10 to 15 percent of any bond portfolio. Their main drawback is that the inflation adjustment is made only when the bond reaches maturity—but federal income tax on the yield is due every year. That's why they work best in a tax-deferred account, such as your retirement fund.

Federal agency bonds: Watch what you buy

These are bonds issued by such entities as Fannie Mae (formerly known as the Federal National Mortgage Association), the General National Mortgage Association (Ginnie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal Farm Credit System, and the Tennessee Valley Authority. (Fannie Mae and Freddie Mac are private companies and receive no federal funding.) They're almost as safe as Treasuries, but for one big difference: Many are callable.

This means that the issuer can "call" your bond—forcing you to redeem it—before it reaches maturity. Typically, bonds are called when interest rates fall drastically, and the agency can save money by calling older bonds and issuing new ones at a lower yield.

Many bond experts recommend mortgage-backed securities. "If the mortgage-backed bonds are intermediate-term, their price sensitivity to interest rate changes is not great," says David Schroeder, head of the taxable bond group and senior portfolio manager at American Century Investments in Mountain View, CA. "And you'll get a bit higher yield than you would from traditional Treasury bonds." In early October, a five-year Fannie Mae bond yielded 3.5 percent. Ginnie Maes are equally attractive, Schroeder says.

Eric Jacobson, a senior bond-fund analyst at Morningstar, recommends a mix of mortgage-backed securities, intermediate-maturity government bonds, and investment-grade corporate bonds. The Vanguard Total Bond Market Index Fund, FPA New Income, and Vanguard GNMA Fund—a Ginnie Mae mortgage-based fund—all fit the bill. Remember, however, that not all federal agencies are alike. For instance, during the farm crisis of the early 1980s, investors in the Federal Farm Credit Banks feared the agency would default on its bonds. Though no defaults occurred, many investors lost money as the crowd rushed to sell out.

Municipal bonds: Do your homework

These are issued by state and local governments, often to pay for public works projects. They're always free of federal tax, and almost always free of taxes in the region where they're issued. But keep munis in your taxable account. They don't make sense for retirement accounts, since without the tax savings, the yields are paltry.

Municipal bonds aren't without risk. In 1994, Orange County, CA, filed for bankruptcy, defaulting on its municipal bonds. Investors lost more than $1 billion. Every year, the Securities and Exchange Commission cites hundreds of local governments for providing potential bond investors with misleading information about their financial condition. So when you consider muni bonds, your pre-investment homework is crucial—or you can rely on an adviser or a mutual fund manager to do it.

Still, you can benefit nicely from high-quality munis, especially in this market. (A good site for online information: www.lebenthal.com .) "Despite last year's big rally, munis continue to look attractive relative to taxables," says Jacobson. In today's market, he notes, investors paying 27.5 percent or more in federal taxes can generally earn a much higher after-tax return than they would from a taxable bond with the same credit rating and maturity. (To figure your individual situation, check The Bond Market Association's online calculator at www.investinginbonds.com .)

Corporate bonds: Not so safe anymore

Many corporate bond investors have suffered recently as bonds long considered high-quality have slipped below investment grade. Thanks to the slow economy and perhaps outdated business strategies, these bonds may now face the possibility of being downgraded to junk bond status. "In the old days, you bought bonds that were single-A-rated or better, and you didn't worry about adverse events that could hurt an individual company," says Hartman. "That's not the case today."

Southern California Edison and Pacific Gas & Electric, two venerable utilities that once offered investment-grade bonds, toppled in California's energy crisis. Lucent Technologies, Finova Capital, Xerox, Rite Aid, and Polaroid have seen their credit ratings sink. Last year, says Hartman, twice as many US companies were downgraded as upgraded.

But don't write off high-grade corporate bonds entirely: Some are still worth an investment. One example: a 10-year bond issued by Bank of America that recently yielded 6.3 percent.

Do your homework about the current financial state of even the best-known companies, just as you would before buying their stock. Be wary of those with bond ratings in flux. On the other hand, a steady series of upgrades is a good sign. Check ratings at Moody's Investors Service ( www.moodys.com ) Standard & Poor's (www.standardandpoors.com ), Fitch (www.fitchibca.com ) or any financial Web site that offers ratings data.

You might have trouble finding the highest-quality corporates, however. "Triple-A corporate bonds are now a very, very small universe," says Cohen. In fact, only nine US corporations currently carry Moody's top Aaa credit rating: American International Group, Berkshire Hathaway, Bristol-Myers Squibb, ExxonMobil, General Electric, Johnson & Johnson, Merck, Pfizer, and UPS.

"If anyone thinks he's going to put together a diversified, Triple-A corporate portfolio—good luck!" says Cohen. Consider adding slightly lower- grade corporate bonds, including Lehman Brothers and Enron, which Moody's upgraded last spring. But remain wary of bonds below investment grade, at least in this unsettled market. It's wise to avoid buying below investment grade, unless you're getting such bonds in a bond fund.

High-yield bonds: They can shore you up or stab you

Don't rule them out, but be careful. Many high-yield bonds (aka junk bonds) offer yields well above 10 percent. Even some conservative financial advisers think a small part of your bond holdings should include them. But individual junk bonds today can be treacherous.

"Over the past few years, the default rate on non-investment-grade bonds has soared," says Mariarosa Verde, senior director of credit research at Fitch, a rating and research company in New York. "From 1997 to 1999, many deals brought to market were much riskier than in the past. The telecom companies raised enormous amounts of debt in the high-yield market."

You're better off with junk-bond funds than with individual high-yield bonds. "High-yield bonds are cheap relative to their historic levels," says Jacobson. "If you believe that we're not slipping into a deep recession, you might want to add a high-yield fund to your asset collection." Jacobson would hold the high-yield portion of a bond portfolio to 5 to 10 percent—perhaps a bit higher for younger investors.

Bond funds: Professionals do the work

"I'm a great believer in bond funds right now," says Kirk Hartman, "because they give you diversification." (For a selection of Morningstar-chosen bond funds, see "Bond funds to solidify your portfolio".) The US bond market is huge, after all—significantly larger than the US stock market—and new wrinkles are being added daily as bonds are issued.

Funds offer benefits, such as relative safety, particularly in tricky areas like high-yield debt. One solid, general bond fund provides much more diversity than most individual investors could build picking one bond at a time. Moreover, since bond funds buy in bulk, they often get better brokerage deals than individuals do.

The biggest advantage of a portfolio of good bond funds is that, for a reasonable fee, you turn the daily homework and investment decisions over to experienced managers.

On the downside, the management fee cuts into your profit. And some funds charge loads—sales commissions—which cut deeper still. Why pay a fee for Treasuries, for instance, when you can so easily buy them yourself?

And as with stock funds, you don't always know just what the fund manager is buying. In the past, some seemingly investment-grade bond funds were actually salted with risky emerging-market debt, derivatives, and junk bonds. "The Securities and Exchange Commission, and the industry itself, have dramatically curtailed such abuse, but you still have to read the bond fund prospectus carefully to see what the manager is allowed to buy," says Cohen.

Bond funds to solidify your portfolio

N.A.: not applicable. All one- and five-year returns through Oct. 8, 2001, except Metropolitan West Total Return Bond Fund, which is through Oct. 5. All 10-year returns through Sept. 30. All funds are no-load except FPA New Income Fund, which has a 3.5 percent front load. Source: Morningstar

*Though primarily an institutional fund, this is now available at normal minimum investment levels through Charles Schwab & Co.

The author, who is based in Los Angeles, is a Contributing Writer to Medical Economics.

Michael Parrish. Hit a home run with bonds.

Medical Economics

2001;21:53.