October 18, 2000

How to buy bonds

The stock-picking bug is powerful. But not only do bonds sometimes outperform, the proper allocation can boost your overall returns.

By Michael Sivy

Even if you're primarily a growth investor, you shouldn't neglect bonds. In fact, there's a strong case for keeping as much as 25% of your portfolio in fixed-income investments. Primarily, bonds will greatly limit your losses in the event of a correction -- during the 1987 crash, for instance, the S&P 500 plunged 22% in a single day but Treasury-bond prices rose. With that safety net, you can afford to invest some of your money more aggressively, which can actually end up boosting your overall profits.

On average, long-term Treasuries have returned only 6% a year compared with 12% for S&P 500-stocks. But the gap isn't always that big. When stocks start from very high valuations (like those of the past few years), their future returns may average only 7% or 8% a year-- and there may be several years in which stock prices plateau. Similarly, bonds can return a lot more than 6% if you buy at the right time -- usually right before the economy slows and interest rates fall, which pushes up bond prices. Here's a look at the key income choices.

Treasury bonds are fully backed by the U.S. government, so the chance of default is nonexistent. Prices may rise and fall, but all interest payments will be made on time. Another plus is that those payments are exempt from state and local taxes. The bonds of government agencies, such as the Tennessee Valley Authority, are nearly as safe as Treasuries and they pay slightly more. Ginnie Maes, which pass through the interest and principal payments made on mortgages, also pay more than Treasuries.

Tax-exempt municipal issues are often great buys for people in top tax brackets. Over the past couple of years, in fact, municipal yields have been close to Treasury yields even without the tax advantage.

Corporate bonds pay higher yields than government issues, with top-quality issues generally offering at least a percentage point more than Treasuries. And low-quality corporates, known as junk bonds, can yield 10% or more. With higher interest payments, however, comes a greater risk of default, so it's crucial to diversify.

Once you've settled on the type of bonds your looking for, the chief question is whether to buy them directly or through mutual funds. Since fund expenses can be killers, my rule of thumb is to use funds only when professional management and broad diversification are essential. That's certainly true for junk and foreign bonds, and usually for munis as well. Index funds, with their rock-bottom fees, are a valid choice for any type of bonds. But for Treasuries and other high-grade debt, I prefer direct purchases through my brokerage account.