Here at the Fool, we tend to focus most of our time and energy on stocks, believing that equities are the best way to stay ahead of the erosive effects of inflation and build wealth over time. The staid fixed-income sector, on the other hand, is seldom mentioned with any enthusiasm. It's not that we don't appreciate what bonds have to offer. We discuss their merits from time to time and have even devoted a section of our Investing Basics center to a comprehensive profile of their ins and outs. For many, though, bonds are kind of like the friends our parents always wanted us to hang out with: dependable, polite, never reckless ... in a word, boring.
During my rookie days as a financial advisor, a regional manager would sometimes quip that holding a balanced portfolio containing both stocks and bonds was "like driving with one foot on the accelerator and the other on the brake." How true. When the market is cruising full speed ahead with no signs of a bear market policeman, who needs the brake? In the late 1990s, investors could load up on nothing but aggressive stocks and let their portfolios run as fast as the market's speedometer would allow.
Sooner or later, though, those guys with the flashing blue lights will be pointing a radar gun directly at all of us. When the speeding tickets are finally handed out, lead-footed investors with portfolios entirely devoid of bonds will pay the stiffest fines.
Regular or high-octane?
Many people have the attitude that a bond is a bond is a bond. For example, when deciding on a 401(k) allocation, it is not uncommon to see participants devote several hours to striking just the right balance between their own company stock, funds holding promising small caps like CryptoLogic (NASDAQ:CRYP), and those comprised of blue-chip firms such as Procter & Gamble (NYSE:PG). Then, almost as an afterthought, they will pencil in a 10% or 15% portfolio weighting next to the first bond fund they come across.
We are often reminded that a healthy dose of bonds is good for our portfolios and will help cushion the blow of a severe stock market correction. I know, because I used to be one of the people dispensing such advice. And for the most part, it happens to be true. However, many investors begrudgingly allocate a portion of their money to bonds as if they were being forced to eat broccoli -- because they know it's good for them. This can prove to be a costly mistake.
Just as a diversified stock portfolio includes a sampling of both large companies and small companies, of both growth and value stocks, so should a well-rounded fixed-income portfolio have broad exposure. Bonds come in all shapes, sizes, and flavors. Here is a quick rundown on what is available:
Treasury Bonds: These are essentially IOUs issued by the United States Treasury. As such, they are backed by the full faith and credit of the federal government. Because these bonds are considered to be some of the safest investments on the planet, they tend to carry lower yields than bonds with similar characteristics. Treasuries are available in $1,000 increments and can be found in a wide range of maturities, from Treasury Bills (13 weeks to 52 weeks) to Treasury Notes (two years to 10 years) to Treasury Bonds (30 years).
Corporate Bonds: These are issued by publicly traded companies to raise capital. Because corporate bonds are only as safe as the company that backs them, it's advisable to assess the financial health of the firm issuing the debt before lending them your money. Fortunately, ratings agencies like Moody's (NYSE:MCO) have simplified this task, assigning the strongest, most creditworthy companies a rating of AAA. This is followed by AA, A, BAA, B, CAA, and C. Bonds that carry the most favorable ratings are said to be "investment grade" quality, while weaker companies in the lower rungs of the credit ladder issue "junk" or high-yield bonds. Naturally, to compensate investors for the higher risk of default, lower-rated bonds typically pay higher interest rates.
Municipal Bonds: These are debt instruments sold by state or local governments. They are issued for a variety of reasons, such as to raise money for a new water treatment facility. Municipal bonds (known as Munis) are exempt from federal income taxes (as well as state taxes for investors in the state where the bond is issued). Munis are particularly attractive to investors in the upper tax brackets.
While these are the three best-known categories, this list is far from being all-inclusive. For example, those concerned with inflation may be interested in Treasury Inflation Protected Securities (TIPS), whose interest payments can rise to reflect changes in the Consumer Price Index (CPI). And investors who won't need to receive income until a future date might want to take a look at zero coupon bonds. Then there are agency bonds issued by the likes of Freddie Mac (NYSE:FRE), Fannie Mae (NYSE:FNM), and Ginnie Mae. Finally, there are hybrid securities like convertible bonds, and synthetic products such as Collateralized Mortgage Obligations (CMOs) or Real Estate Mortgage Investment Conduits (REMICs).
Hire a chauffeur
As with stocks, there are advantages and disadvantages to purchasing bonds directly versus owning them through a mutual fund. For most people, the latter is probably the best route to take. Not only do the same selling points -- diversification, professional management, etc. -- still apply, but bonds are also more liquid. Individual bond holders in need of cash must wait until maturity or risk selling at a discount.
Most importantly, though, fixed-income investing is not nearly as straightforward as it seems. Some bonds are callable. Others aren't. Some bonds have coupons that are fixed, others are floating, and a few, called step-up bonds, even rise according to a pre-determined schedule. Individual bond owners must decide whether to buy new issues or delve into the secondary markets. They must also be familiar with concepts like death puts, average life, and prepayment risk. Find an expert you can trust, and let that expert worry about portfolio duration and inverted yield curves. One potential caveat -- expense ratios can take a relatively larger bite out of a bond fund's total return, so avoid funds that are weighted down with expenses.
Clearly, assembling a diversified fixed-income portfolio isn't quite as simple as throwing some money into a corporate bond fund and assuming you have an adequate safety net in place to limit losses in a falling market. Even if you did feel that corporate bonds were the right place to be, there are still other questions that must be answered. Should you seek the safety of investment-grade issues, or do you prefer the juicier payouts in the high-yield arena? Should you park your cash in a portfolio of ultra-short-term maturities, or do you feel more comfortable venturing out into the longer end of the yield curve?
There are some funds -- usually containing the name "Strategic Income" -- that invest in a broad cross-section of fixed-income markets and are designed to be a core, all-in-one holding. However, you might also want to spice up your portfolio with some international fare, and if so, Motley Fool Champion Funds has a candidate for you. Shannon Zimmerman's standout global bond fund travels from established markets in Europe to emerging ones in Brazil and China seeking out high-quality bonds. When stocks swooned in 2002 and 2003, it escaped the carnage, delivering returns of better than 20% both years.
Or perhaps you might want to boost your payout by testing the high-yield waters. In that case, I recommend another market-beating Champion Funds pick: a high-yield winner that is less volatile than its peers, has a rock-bottom expense ratio, and sports a whopping 7.1% current yield. By the way, its manager has been at the helm since Ronald Reagan called the White House home.
(If you'd like to peek at these two bond funds, as well as nearly 30 additional Championship-caliber funds, consider a 30-day free trial to Champion Funds. You'll have access to everything ever published in its pages, and there's no obligation to subscribe.)
Foolish final thoughts
To a certain extent, the composition of your portfolio will be determined by your own risk tolerance and financial objectives, though interest rates will also likely be a factor. Not surprisingly, interest rates have an even more pronounced impact in the bond markets than in the equity markets. Most of us are familiar with the inverse relationship between bond prices and bond yields, but not everyone is aware that long-term bonds are much more susceptible to rate changes than are short-term bonds, or that lower-yielding bonds tend to be more rate-sensitive than higher-yielding ones.
So go ahead and drive your portfolio with one foot on the brake. You never know when you might need to slow down in a hurry.
CryptoLogic is a Motley Fool Hidden Gems recommendation; Fannie Mae is a Motley Fool Inside Value pick, and Moody's is a selection of Motley Fool Stock Advisor.
Fool contributor Nathan Slaughter still won't eat broccoli. He owns none of the companies mentioned. The Fool has a disclosure policy.
