Don’t Chase Bond Safety With More Risk

by Marc Bastow | May 16, 2013 12:19 pm

The broader indices have chalked up roughly 150% in returns since the depths of the financial crisis, with even so-called “defensive” stocks like McDonald’s (NYSE:MCD[1]) and Coca-Cola (NYSE:MCD[1]) roughly doubling in that time.

It’s safe to say the stock market is roaring.

And yet, according to Jeff Sommer[2] of The New York Times:

So if everything is going so well for investors — and particularly for retirement investors, who are getting appreciation alongside more income as dividend stocks continue to throw out bigger quantities of cash — why are more people diving into bond funds than stocks or stock funds?

First things first: Bonds do provide some downside protection when markets fall; Walter Updegrave at CNNMoney writes that[3] over a recent 13-year period in which the stock market lost 50% of its value twice, the bond market hasn’t dropped more than 9.2% at any one time.

But bond funds still can be dangerous to your (portfolio) health. Articles by Lauren Lyster[4] and John Waggoner[5] lay out some compelling arguments about the dangers of “safe” bond funds:

If you want to exercise some level of control over your bond portfolio[6] — and I am definitively in favor of bonds as a vital part of  a core retirement portfolio — take some time to research individual bonds either on your own or with a financial adviser.

Several years ago, I made the decision to sell out of bond funds and invest in a portfolio of individual (municipal) bonds. I was tired of paying steep management fees and looking at my statements wondering what bond managers were doing and why on a monthly basis. Today, I can look at every bond in the portfolio and determine if a strategic shift is in order. I also can easily see the maturity date(s), and know with some certainty no matter what happens, I will get all my money back.

This isn’t as daunting a task as some might believe. All the big boys have bonds out there that are easy to research and obtain through a brokerage firm. As an example, AAA-rated  Johnson & Johnson (NYSE:JNJ[7]), and Microsoft (NASDAQ:MSFT[8]) each have five-year issues in the market, while A-rated AT&T (NYSE:T[9]) has a six-year issue available. Instead of a bond fund, you could purchase a piece of each of these bonds, which mature in 2018 and 2019 — maturity dates that take some of the longer-term risk out of your bond portfolio.

To be fair, because they’ve been out there awhile, any of the three will cost you well over par value, forcing the yields down to 1.2% for the JNJ bond, 1.6% for the AT&T bond and 1.65% for the MSFT bond.

Buying these bond stalwarts might seem silly; after all, none of them yields close to 2%, a good starting p0int for investment relative to the S&P 500 average dividend yield. But you will get uninterrupted payouts and solid credit risk … and if rates move on you, you also have the knowledge that your money will be returned in full on the maturity date.

In other words, a sounder sleep.

Of course, if you want even more comfort, you can simply buy that Treasury security outright. The U.S. government has the safest risk profile of all.

At this point, everyone probably has some level of concern about when they should jump off this runaway stock train — especially those who are getting closer to retirement. As far as where you should put that money, I would strongly suggest bonds, and more specifically, individual bonds over bond funds. While it might take a little more time and effort on the research and management fronts, you can get a better grip on your risks and more easily understand your rewards.

Marc Bastow is an Assistant Editor at InvestorPlace.com. As of this writing, he was long MSFT and JNJ.

Endnotes:
  1. MCD: http://studio-5.financialcontent.com/investplace/quote?Symbol=MCD
  2. according to Jeff Sommer: http://www.nytimes.com/2013/05/12/your-money/forecast-for-a-20000-dow-still-holds.html?pagewanted=all&_r=1&
  3. writes that: http://money.cnn.com/2013/04/01/pf/expert/bond-funds.moneymag/index.html
  4. Lauren Lyster: http://finance.yahoo.com/blogs/daily-ticker/nest-egg-may-contain-sticks-dynamite-131223370.html?vp=1
  5. John Waggoner: http://www.usatoday.com/story/money/columnist/waggoner/2013/04/25/investing-dangers-in-bond-funds/2113479/
  6. exercise some level of control over your bond portfolio: http://investorplace.com/2013/02/the-bond-portfolio-blues-aapl-msft-xom-jnj-tlt/
  7. JNJ: http://studio-5.financialcontent.com/investplace/quote?Symbol=JNJ
  8. MSFT: http://studio-5.financialcontent.com/investplace/quote?Symbol=MSFT
  9. T: http://studio-5.financialcontent.com/investplace/quote?Symbol=T

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