The all-weather bond portfolio - CEO Finance

Chief Executive, The, Nov-Dec, 1992 by William N. Shiebler

Tired of money market yields but afraid to relinquish security? One answer may be a diversified portfolio of government, municipal, and corporate bonds.

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.

OPTIMUM MIX

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 California, where the top state tax rate is 11 percent. Assuming you are subject to the top federal rate, 31 percent, you would have to find a CD yielding more than 10 percent to give you an equivalent after-tax yield higher than the state's 6.4 percent munis.