By Art Rothschild and Joel Dresang

Given continued volatility in global stock markets, it is nice to know that bond investors have been able to benefit from ongoing interest payments and the relative stability that the bonds in their portfolio have provided this year. 

When 2010 started, all eyes were on the stock market.  Given how well bonds and stocks had done in 2009, the most expected scenario was for rising interest rates as the economy continued to strengthen and for stock prices to continue to rise while the value of bonds would fall. But things haven’t turned out that way. 

This has actually been a great year so far for bonds and a difficult one for stocks. How long that trend continues is anyone’s guess. Over long periods, though, bonds always fit into most portfolios. 

Essentially, a bond is a loan.  For instance, investors buying U.S. Treasury bonds are in effect lending money to the federal government.  Likewise, investors lend money to states and municipalities that issue municipal bonds and to corporations issuing corporate bonds.

Bonds are issued for different lengths of time with either fixed- or variable-interest rates.  The interest rates can vary according to a bond issuer’s credit rating – which is based on the issuer’s creditworthiness.

Often, individual bonds get packaged together into bond funds, which are pools that either are actively managed by professionals or sometimes managed to mimic a particular index.

How Bonds Can Fit in Portfolios

Investors commonly use bonds and bond funds to provide a predictable income stream from interest payments as well as some level of certainty that issuers will pay back the original investments when the bonds mature.  Also, bonds traditionally act as a buffer to mix with stocks in long-term portfolios.

Specific types of bonds can offer various benefits. For instance, investment income from municipal bonds is exempt from federal income taxes – and in some cases from state or local income taxes – which can make them attractive to high-income taxpayers. 

Foreign-issued bonds and global bond funds can provide a hedge against the potential decline in value of U.S.-based investments.

Also, taxable bonds, particularly in qualified retirement accounts, can provide a fairly high yield or income for current or future retirement distribution.

Recent experiences help illustrate how bonds and bond funds can fit in some portfolios:

  • For one client, we acquired three types of funds for income and capital preservation in his individual retirement account – a fund specializing in high-quality corporate and government bonds, one investing in a broader universe of bonds with both overseas and domestic issuers, and a fund investing in higher yielding bonds as well as in stocks of companies known for increasing dividends.
  • For a relatively young client in a high tax bracket, we monthly acquire shares in a municipal bond fund that helps him accumulate a portfolio of relatively safe bonds sheltered from federal taxes.
  • For another client, we periodically purchase individual municipal bonds to fill in the rungs of a “bond ladder” as other bonds mature.

Some investors want to own individual bonds. Our preference for most investors is to seek funds managed by the best available bond managers who can anticipate and adjust the portfolios as the winds of change are anticipated or begin to blow.

Risks of Bonds and Bond Funds

First and foremost, investors should never acquire bonds and bond funds based simply on yield.  Higher yields generally reflect lower credit quality.  At the same time, higher yielding or “junk” bonds should not necessarily be shunned.  They should be acquired only after comprehensive research in the context of a well-diversified portfolio.

We never buy individual junk bonds. We do, however, employ knowledgeable managers who are able to sift through the many issues to find a relatively safe higher yield and possibly capital appreciation while protecting against loss of principal.

As U.S. Treasury bonds are perceived to have the highest quality, they correspondingly have the lowest yields.  Again, we prefer to employ fund managers who use U.S. government issues in funds that can provide higher yields while still diversifying the portfolio among different maturities. 

Generally, the longer the maturity, the higher the yield.  But longer maturity also can mean more sensitivity to interest rate fluctuations.  When interest rates go up, the value of longer-term bonds tends to go down more than those with shorter maturities.  By controlling the average duration, investors can try to manage the risk of potential loss in value caused by interest rate increases.

Municipal bond investors risk the possibility of the default of a municipality or revenue project tied to a bond.  This risk can generally be minimized by selecting higher-rated municipal bonds and higher-quality municipal funds.

Investors in foreign or global bond funds have to be attuned to risks associated with bonds issued in currencies other than the U.S. dollar.  In cases where those currencies decline in value compared to the U.S. dollar, the investor can experience declines in the investment value. 

In short, although there are many choices and considerations, investors can always add income, stability and balance to diversified portfolios through professionally selected individual issues and well-managed bond funds.

Arthur S. Rothschild, J.D., CPA, CFP is a vice president of Landaas & Company. This article was adapted from one of Art’s monthly contributions to the Racine Journal Times.

Joel Dresang, vice president of communications at Landaas & Company, contributed to this article.

initially posted September 9, 2010

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