The Role of Bonds in Your Portfolio

If our search for the “holy grail” of investing were only about safety and simplicity, bonds would win hands down.

Bonds are basically IOUs. Let’s say you purchase a 5-year bond for $10,000, its face value. The bond pays you a dividend of maybe 4% a year. At the end of the five years, you get your $10,000 principal back.

Even bonds backed by the U.S. government cannot quite guarantee returns — but they come awfully close. Much closer than stocks, stock funds, and, of course, riskier investments, such as commodities.

Bonds are, in fact, the perfect complement to riskier investments. If your stock returns are shrinking before your eyes, you can always fall back on the certainty of your bond dividend payments. They act as a reliable safety net and effective diversifier of your portfolio.

Bonds have one job to do: Preserve capital. That’s it. But sometimes they don’t do it. Inflation is the culprit. If the interest you make on the bond is lower than the average rate of inflation over the life of the bond, your investment has lost you money in real-money terms. Throw in taxes, and you have lost even more money in real-money terms.

Inflation seems to be on the way up, though not drastically. The fed interest rates are also increasing . . . to keep inflation in check. Bond rates are modest. Some experts would say overvalued. You’re not getting a fair market rate.

This is clearly not the best market in which to buy bonds. But since bonds should be a part of any investor’s portfolio, here are three smart ways to play the bond market right now:

1. “Ladder” your bonds.

Time your bond investments so one matures every two years. You  can do that by investing in 1-, 3-, 5-, 7-, and 9-year bonds.  When your 1-year bond matures, reinvest the principal in a  10-year bond. Your series of bonds will now mature in 2,4,6,8,  and 10 years. Each time a bond matures, reinvest in a 10-year  bond. If bond yields are getting higher, you’re never more  than two years away from taking advantage of those higher rates. If they’re headed down, you still have several bonds invested at the higher yields.

If you ladder your bond investments right, you could have them set up in such a way that you would be able to support a comfortable retirement lifestyle on your maturing bonds alone. (This is something that Michael Masterson has done.)

2. Buy and hold.

Investors exhibit the same shortsighted behavior with bonds that they do with mutual stock funds. Investors should — but typically do not — buy and hold their bonds. And that’s the only way you know for sure that you’ll get your full principal back. If you sell before maturity, you risk having to discount your bond price. So plan ahead. If you’re thinking of investing in a business five years from now, invest in a 5-year bond, not a 10-year bond.

3. Choose carefully.

There are 5,000 to 8,000 investment-grade bonds available to you. If you are new to bonds, I suggest you bypass corporate bonds and government bonds from agencies such as the Farm Credit Financial Assistance Corp. Invest in U.S. Treasuries instead. You can buy these bonds direct and avoid broker commissions.

Call the U.S. Bureau of Public Debt (800-722-2678) for an application or download the form online at the government’s commission-free Treasury Direct website. Click on “about” in the upper right corner of the home page. In the second paragraph, click on the link “Electronic Services for Treasury Bills, Notes, and Bonds.” Under “Self-Service Options,” click on “Forms & Brochures.” To get the application form, click on the “PDF” of the top form listed (“NEW ACCOUNT REQUEST”).

Payattention to these three important points and your bond portfoliowill be in good shape. But here are some more things that youcan — and should — do:

Go ultra-short.

The rates for 6-12 month bonds aren’t very high but they’re better than money market rates. Think of what you would do if stock prices were falling. You would get out of some of your stock positions and find opportunities to reinvest in stocks with better values. Right? Same here. In 6 or 12 months, you can reassess your bond positions and look for better value opportunities.

Invest in a bond fund.

There are plenty to choose from. There are ultra-short and short-term funds, in addition to intermediate-term and long-term funds. There are high-yield funds, as well. High-yield (“junk”) bonds have recently come down to earth. In fact, there’s one high-yield bond fund among the top 10 performing funds of the last year, as listed in CBSMarketWatch (Pioneer Global High Yield Fund Class A Shares).


and short-term funds have not done well recently. Long-term funds have done better. And emerging-market funds have done very well. Four of them have made the top 10 list, along with three emerging-country debt funds (a close cousin). Get familiar with preferred stocks, which essentially act as bonds.

Many companies offer preferred stocks that provide dividends at favorable yields. Richard Lehmann notes in his Forbes Soapbox column that “the bond market is overvalued at all rating levels. The preferred market is undervalued from the BB-rated level and up. These securities are called ‘stocks,’ but they are really an array of securities that could hardly be described as equity.”

Invest in foreign bond funds.

This is a play on the dollar that assumes the dollar will continue to slide. You have to be careful. Morningstar analyst Lynn Russel says that currencies “bring a lot of volatility to the table.” If you notice the dollar strengthening, sell right away, she warns. You can make the same play closer to home with U.S. mutual funds investing in foreign debt. American Century Intl Bond-Inv and FFTW International are just two of several funds that do this, according to Forbes. Invest in TIPS and I-Bonds.

Treasury Inflation-Protected Securities (TIPS) rise with the inflation rate. The dividend rate stays the same but, as the same percentage of a higher principal, it will also go up in absolute terms. At the end of the maturity period, you’ll get the inflation-adjusted principal. I-Bonds carry a low fixed interest rate plus the inflation rate tacked onto it. You get the accumulated interest when you cash out on the bond or it matures. Both TIPS and I-Bonds are exempt from local and state taxes.

Buy top-graded munis.

You cannot control inflation. But you can reduce your tax payments on bond returns by buying municipal bonds (munis). Like TIPS and I-Bonds, they are exempt from state and federal taxes. Rates become almost a third higher if you’re in the top tax bracket.

So here’s the point . . .

Bonds will never make you broke while you’re sleeping. You should make them part of your overall investment portfolio for that reason alone. Ladder your bonds. Buy and hold. And choose carefully from among the thousands of investment-grade bonds available. If in doubt, munis and U.S. Treasuries are always safe bets.

Yes, bonds are definitely part of the equation. But the “holy grail” that we are searching for is still out there. I can feel it. We’re getting very close. Stay tuned. Next week, I have a revelation in store for you that you won’t believe.