When it comes to investing, everybody loves to talk about stocks. Most of us can wax rhapsodic about the latest biotech highflier or blue chip darling we just picked up, but bonds are often mentioned only in passing: “Oh, I also own a bunch of Wisconsin Power Authority municipals.”
But treating bonds like second-class securities is a recipe for underperformance. By contrast, blending stocks and bonds offers diversification and protection from market downdrafts-particularly important for CEO investors interested as much in security as in yield. But take this logic one step further: Blending bonds in fashioning the fixed-income segment of your portfolio can leave you well-prepared whether the economy remains in the doldrums or shifts into high gear.
Given the vast array of bonds and bond products on the market, we recommend that many of our high-net-worth clients invest in a combination of municipal, high-yielding corporate, and government bonds. Think of this as an all-weather bond portfolio: One possible mix would be 50-30-20, respectively. Beyond that, take care to sidestep some common pitfalls of bond investing: Don’t fall in love with yield, don’t neglect an investment’s long-term consequences, and don’t be afraid to restructure your portfolio should economic circumstances change.
A BRAVE NEW WORLD
Changes in the capital markets are making bond buying more complex; this requires a greater focus by investors. Most of the recent activity resulted from a lengthy and profound drop in interest rates. With long bonds yielding 7.8 percent and T-bills at 3.7 percent, interest rates-especially on the short end of the yield curve-have declined dramatically over the past few years. This movement has had a major impact on the bond market. Some investors who several years ago bought municipal or corporate bonds sporting juicy, double-digit yields didn’t read the fine print: A great many of these issues are callable. Thousands have had to bite the bullet when rich 12 or 13 percent yields were called, and the only available investments were paying maybe half as much.
The point: When it comes to bonds, you must pay attention and be decisive.
An example: A few years ago, some executives I know bought Washington Power municipal bonds that carried an 11.2 percent yield to maturity and sold for $130. They
were pleased as punch to own them, but a closer look would have revealed there was a very good chance these bonds would be called.
These investors chose to ignore that possibility and instead focused on the high current yield. A few years later, the bonds were called at $102, and investors absorbed a 21 percent loss of principal. A few years ago, some other investors I know blindly snapped up Ginnie Mae bonds with a 15 percent coupon. Unfortunately, interest rates were dropping fast, and their principal was paid down at warp speed.
Here’s another grim tale: A guy in my car pool owned some municipal bonds yielding 14.75 percent. We kept telling him they were going to be called, but he stubbornly refused to give up that yield. If he had acted earlier he could have locked in a yield over 8 percent. Now he’s stuck with $300,000 he needs to reinvest, and the best he can do today-with comparable risk-is about 6.25 percent.
I’m recommending that he put about 15 percent of that into some riskier 11.5 percent Dayton (OH) Emery Air Freight bonds. But for the bulk of his portfolio he must accept far less.
Another place pinching investors with lower rates is good old Hometown Bank & Trust. With CDs and money-market accounts paying out the skimpiest yields in decades, millions of Americans are siphoning their dollars out of banks and into mutual funds. Fund companies have responded by creating myriad new products, up and down the yield curve, to meet the needs of virtually every investor. However, many investors are still trying to find yields that match what they reaped several years ago.
It is absolutely critical to understand that today’s 8 percent fixed income instrument is much more risky than an 8 percent money-market fund several years ago. In sum: Don’t get sold on yield. Anything yielding more than a T-bill, CD, or money-market fund does so for a reason and carries principal risk. Calculate a bond or bond fund’s expected total return and balance that against the risk involved. Purchasing just on a yield basis is like buying a sports car and not knowing if it has brakes.
Municipal bonds should comprise roughly half the bond portfolio of a wealthy investor. Munis always make sense, partly because the tax savings they offer may be substantial. (My wife and I have sizable municipal and municipal bond fund holdings.)
Say you live in
Right now in the municipal arena, higher-grade bonds are generally the most attractive. That’s because their yields-compared with those of lower-quality bonds-are at a historical high. Particularly recommended are Triple-A, 10-year munis yielding between 5.9 percent and 6.1 percent. Don’t bother going 30 years for those yielding 6.5 percent-it’s not worth the risk.
The safest municipals are insured bonds, those backed by one of several AAA-rated insurance companies. These days, about a third of all municipals are insured. An insurer pays back your interest and principal if the issuer defaults-you give up between 10 and 15 basis points for this coverage. Also look for pre-funded municipals, short- to intermediate-term bonds backed by Treasury securities. And find out whether your bonds are subject to the alternative minimum tax. If you have enough deductions to lower your effective tax rate below 24 percent, the AMT kicks in and requires you to add back into your taxable income such items as tax-free interest on certain bonds.
Another potential plus for munis: Regardless of who wins the election this year, top tax rates could rise, making these bonds even more valuable.
In government bonds, look into five-year Treasury notes yielding about 6.4 percent. Intermediate bonds are an investor’s friend: They produce a hefty portion of the returns of long bonds with much less principal risk. Too, government bonds are exempt from state tax, so they make more sense for someone who lives in a state with high income taxes. Also, except for certain long bonds, Treasury securities are not callable.
Treasuries are easy to buy from the Federal Reserve, either without a sales charge or with a modest charge from banks or brokers. The minimum investment is $10,000 with $5,000 multiples thereafter. Since their credit quality is uniform, choosing Treasury bonds involves deciding where you want to be on the yield curve. You can also buy government agency bonds that have slightly higher yields-although these come with a small amount of risk.
Of course, you can pick from a wide range of Treasury mutual funds with various maturities and objectives. There are also funds that blend Treasuries with government agency bonds such as Ginnie Maes to produce a higher yield (though, again, not without some additional risk).
With high-yielding corporates, meanwhile, diversification is critical. A mutual fund is a good way to play this game.
Frequently, wealthier investors don’t take enough risk. But purchasing high-yield bonds will increase the risk/reward mix of your portfolio. Right now, intermediate-quality corporates yield about 11.5 percent-for someone in the 31 percent tax bracket, that is equivalent to an after-tax yield of 7.9 percent. Corporates carry a greater principal risk, but investors with a longer-term horizon will find these securities fit the bill.
Some long-term strategies: By ignoring principal fluctuations and reinvesting the coupon over time, you can reap sizable benefits. Reinvesting interest is another way of “dollar averaging” into the high-yield market. Over the past decade, for instance, hospital bonds have been perceived as risky. Indeed, their prices have been volatile. Yet an investor who stuck with them would have garnered excellent returns. There are probably still opportunities in this area.
Let’s tally the results. Last year, the combined, weighted, after-tax yield of this portfolio of municipals, government, and high-yield bonds would have been 6.5 percent. With inflation running about 3.5 percent, that’s not bad.
A coda about mortgage-backed securities-products created in line with the trend toward securitization of less-liquid types of assets. Currently, these bonds are yielding a bit more than 7.5 percent and, therefore, are attracting significant attention.
But a strong caveat: Though investors can be richly rewarded in the MBS arena, they should be aware of the potential pitfalls. One problem with securities such as those issued by Government National Mortgage Association (Ginnie Mae) is prepayment risk. When interest rates fall, many homeowners refinance their mortgages. Similar to circumstances surrounding the recall of a bond, that means bondholders have their principal returned to them and must reinvest at a lower rate.
With all mortgage-backed bonds, the accounting involved can be difficult and individual investments perilous. If you’re interested in using such securities to enhance yield, mutual funds are the way to go.
Ultimately, the mix of a bond portfolio should be determined by an individual’s investment needs and the economic outlook. Regarding the latter, now is not the time to bet on interest rates making a strong move up or down. Our economists believe we are entering a period of fairly stable interest rates. Long rates are expected to decline to just under 7.75 percent, while short rates will probably begin to ratchet up a bit to about 4.2 percent by next spring, as the recovery builds momentum.
The all-weather portfolio, however, should fare well no matter which way the wind blows. If the recovery picks up steam, you may suffer a little principal erosion in your government and municipal bond portfolio as short-term rates rise, but your high-yield bonds will benefit.
On the other side of the coin, if the economy fails to accelerate, your high-yield bond position could be crimped, but the rest of your portfolio would hold strong.
William N. Shiebler is senior managing director of The Putnam Companies, a Boston-based investment-services firm with assets of $60 billion.