Focus On Personal Finance
In a Bear Market, Think Bonds
Fixed-income investing can offer positive returns and low risk.

BY RICHARD J. ALPHONSO, JD, CPA/PFS, M.S.T., AND RAYMOND M. HAWKINS, M.B.A., CFA 

As the bear market drags on, many investors are looking for alternatives to stocks. Fixed-income investing offers two benefits in this current environment -- positive returns and low risk.

Fixed income should be a part of your core portfolio in any environment. Large institutional investors typically allocate at least 20% of total portfolio investments to fixed income. A 30-50% allocation to bonds for moderate-risk investors isn't uncommon today.

In this article, we'll outline a sound strategy for investing in bonds and briefly discuss the types of bonds that may fit into your fixed-income portfolio.

MINIMIZE RISK

The best fixed-income strategy to minimize overall risk is to build a portfolio of laddered maturities. With this strategy, you buy equal amounts of bonds across several points on the yield curve. The yield curve is a two-dimensional plot of the yield-to-maturity on treasury bills, notes and bonds for the range of maturities from 1 month to 30 years.

With a portfolio of laddered bonds, you'll achieve a weighted average yield across the range of your maturities. The yield curve rarely moves in parallel fashion at all points, and a laddered portfolio will insulate against severe portfolio price movements associated with interest rate changes.

Reinvestment risk is minimized by the continuous opportunity to buy new bonds with maturing proceeds. The weighted average maturity of the portfolio can be shortened or lengthened based on interest rate forecasts. Just remember, portfolio concentrations around any maturity date can be a gamble.

CHOOSE FROM A VARIETY OF BONDS

Once you've decided on a fixed-income investment strategy, you can choose your bond portfolio from among the following sectors:

Treasuries. Treasury bonds are the "gold standard," representing the highest quality in the marketplace. The lowest yields for taxable investors accompany this credit quality.

Agency bonds. The federal government sponsors agencies to administer programs related to residential mortgage lending, student loans, banking and agriculture. These agencies issue debt to finance their programs. Agency bonds carry an implied AAA rating (highest) because they're associated with the federal government.

Municipal bonds. For investors in the highest income tax brackets, tax-free municipal bonds usually offer the highest spreads over treasuries compared with corporate debt. Investors tend to rely on the ratings given to specific municipal bonds due to their lack of familiarity with many issuers, such as local school districts and hospitals.

Mortgage-related securities. This is the largest segment of the U.S. bond market. The major issuers of these securities are the federal agency "Ginnie Mae" (GNMA) and the federally sponsored corporations "Fannie Mae" (FNMA) and "Freddie Mac" (FHLMC). Owning these securities is like being on the receiving end of monthly mortgage payments. Consult a broker or adviser regarding the weighted-average life and prepayment characteristics of mortgage-related bonds before investing.

Corporate bonds. The name of the game here is credit quality. The rating agencies, such as Standard & Poor's and Moody's, are very influential in this sector. They assign ratings, ranging from AAA to so-called "junk," based on an individual company's financial health.

START BUILDING A PORTFOLIO NOW

Don't wait for higher interest rates to invest in bonds. With some planning and adviser consultation, you can begin now to build the proper fixed-income portfolio for all seasons.

Richard J. Alphonso, JD, CPA/PFS, M.S.T., and Raymond M. Hawkins, M.B.A., CFA, are president and investment analyst/financial planner, respectively, of The Financial Advisory Group, Inc., in Houston. The Financial Advisory Group {(713) 627-7660} provides personalized fee-only financial planning, investment management and business consulting services.