Thursday, February 19, 2009

Bond market presents challenge to conservative investors

The Fixed Income Challenge

One of the biggest challenges in the markets today comes from an unlikely source – bonds. Traditionally, bonds are the boring part of a portfolio, generating a bit of interest income while offsetting volatility from stocks.

Bonds run the gamut from extremely safe to highly speculative. For most portfolios, we recommend safe bonds with shorter maturity dates. We often use managed bond funds for added diversity and expertise. At different times, we might use bond substitutes - bank certificates or commercial money market funds - in this portfolio segment. These are rarely a good long-term solution, however.

Rates have fallen to ridiculous levels. Treasury bonds – often considered the safest investment of all – are paying less than one percent. Money market funds, comprised of the shortest possible maturities, slipped into that range as well. Obviously, it’s hard to stomach a large portfolio segment locked into such dismal annual returns.

And, yet, what’s the alternative?

There are genuine dangers in reaching out for higher rates. With bonds, higher rates come directly from higher risks. You either extend maturities or seek lower-rated bonds. Lower-rated bonds carry some risk of default (especially in today’s environment), and longer bonds will suffer when rates eventually rise again. It might pay to speculate in those arenas, but it’s too dangerous for large amounts or most of our clients.

No simple solutions

In some ways, the bond market is more complex than the stock market. First of all, there are tens of thousands of issuers. Virtually every level of government from Washington, D.C. to the sewer districts of rural Missouri creates and sells bonds. School districts, universities, and library systems, along with thousands of corporations and churches, issue bonds.

The terms of those bonds differ from issuer to issuer. The stated interest rates, payment schedules, and maturity from the very same issuer can range from six months to 30 years. There are insured bonds, uninsured bonds, revenue bonds, and general obligation bonds.
Navigating these treacherous waters requires a sure and steady hand, with considerable experience and understanding. Multiple bond variables – issuer, maturity, credit quality, and type of bond or deposit – interact with the extreme economic environment in unique and peculiar ways. The 2008 “Credit Crunch” was largely the result of some widespread peculiar pricing anomalies with mortgage-backed bonds.

Because of all of these variables, we’ve been recommending bond funds to our clients. Bond funds, when run by experience managers, give the same advantages as a stock mutual fund. No one investment can tank the fund if it is properly diversified.

If you’re looking at bond funds, examine the track record of the funds against the track record of bond indexes. Look at the quality of the firm and the length of employment of its management. And know, that like everything else, there are no guarantees. There are no silver bullets, especially in this market.

Some final points to consider

One knock against bond mutual funds is that they never mature. A fund manager either trades the bonds or reinvests the proceeds when they mature. Some folks prefer the simplicity of a single bond with a guaranteed maturity. It is simpler to use that approach, but it’s a limited solution with limited investment potential.

Bond funds offer a couple of advantages. Trading and pricing costs born by individuals are often two to three times higher than institutions. Also, diversification offers more safety, especially with corporate, municipal, or high-yield bonds.

One last observation seems important. There are some unusual moments where bank deposits (certificates or even demand accounts) yield more than bonds. In some cases, that may be true today. Pay special attention to FDIC coverage limits because high promotional rates may signal a bank’s need for capital. Such opportunities may bring brief periods of profitability, but rarely offer a good longer-term solution.
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Dan Danford is founder and CEO of Family Investment Center in St. Joseph, Mis­souri. The firm is a commission-free investment advisor registered with the SEC. Danford and other advisors at the firm specialize in managing large portfolios of traditional investments. They do, however, advise investors on a broad range of financial services. More about Danford and this unique firm can be found at www.familyinvestmentcenter.com. Also, the firm’s family finance blog is found at http://familyinvestmentcenter.blogspot.com. Follow Dan on Twitter @family_finances.

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