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3 Reasons to Own Bonds

To earn income, to cushion volatility and to beat stocks


Gurus are so mad they’re popping their Armani collars. “It’s a bond bubble!” they shout. Year-to-date, according to Merrill Lynch, investors worldwide have poured $240 billion into bond funds. Meanwhile, those same investors have added only $9.8 billion to equity funds — and have actually withdrawn $72 billion from stock mutual funds other than exchange-traded funds.

Maybe the masses are crazy. Or maybe they’re crazy like a fox. To figure out which it is, let’s review the three reasons why the Profitable Investing family owns bonds anyway.

Income First and Foremost

The first reason, of course, is for the income. Granted, interest rates have fallen dramatically over the past three decades, and especially since the financial crisis of 2007–08. However, not all bond yields have plummeted to the same degree.

For example, medium-quality corporate bonds yielded as little as 112 basis points — 1.12 percentage points — more than Treasury paper of comparable maturity in February 2007, before the crisis.. Today, the spread stands at just over 200 basis points.

Income Recommendation: As a result, a fund like Vanguard Intermediate-Term Investment Grade Fund (MUTF:VFICX), can still yield 3.3%, based on the past three months’ distributions — even with Treasuries of comparable maturity stuck around 1%.

VFICX features an average maturity of 6.3 years for the bonds in its portfolio. Thus, if interest rates were to climb in the years ahead (as seems inevitable at some point), it wouldn’t take too long for the fund to replace maturing bonds with higher-yielding new issues. Conservative investors appreciate that sort of protection.

Volatility Cushion

The second reason to own bonds, even at today’s relatively low yields, is that they protect you against stock market volatility. When stock prices fall, bond prices tend to fall a good deal less — and may even rise.

Think back to the stock swoon in the summer of 2011. The nasty debt-ceiling fight in Washington, coupled with the first-ever downgrade of the U.S. government’s credit rating, sent investors scurrying for the exits. For the third quarter of 2011 as a whole, the S&P 500 stock index dropped 13.9%, including reinvested dividends.

Over the same period, VFICX gained 2.2%, performing beautifully as a hedge against the stock market turmoil.

For an even heavier-duty Wall Street shock absorber, you might consider a position in long-dated U.S. Treasury bonds. I’m not fond of the low yields on Treasury paper nowadays. Nonetheless, the fact remains that in times of financial stress, investors flee to the perceived safety of Uncle Sam’s IOUs.

Volatility Recommendation: During that notorious third quarter of 2011, despite all the bad behavior by our elected officials, T-bond prices skyrocketed. An exchange-traded fund that tracks the sector, iShares Barclays 20+ Years Treasury Bond Fund(NYSE:TLT), soared 29.6%.

Frankly, I don’t expect TLT to duplicate that showing in any quarter soon. Still, I’m impressed with the resilience T-bonds have displayed during stock market rallies over the past few months. If the Dow were to skid again, I’m confident TLT will help buoy our portfolios.

(Some) Bonds Beat Stocks

There’s a final good reason to own bonds. One type of bond has outperformed stocks for a number of years — and may continue to do so through the middle of this decade or beyond. I’m talking about high-yield (so-called “junk”) bonds.

Few investors realize it, but junk bonds have produced a higher total return — capital appreciation plus interest income — than the S&P 500 index since 1995.

How is that possible? Cash yield is the key. For nearly two decades, the interest coupon on junk bonds has exceeded, by a wide margin, the dividend yield on most stocks. The spread has been so wide, in fact, that stocks haven’t been able to generate enough capital gains to keep up.

Junk-Bond Recommendation: That advantage continues today, albeit to a more muted degree. For instance, a conservatively managed vehicle like Wells Fargo Advantage High Income Fund(MUTF:STHYX) is throwing off a 5.8% yield, based on the past three months’ distributions. By contrast, Vanguard’s S&P 500 stock-index fund yields only 1.9%.

Will stock prices rise 3.7% a year faster than junk bond prices ad infinitum? Maybe, but I wouldn’t bet my bottom dollar on it. Keep a modest stake in “junk.”

Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk “value” approach has won seven “Best Financial Advisory” awards from the Newsletter and Electronic Publishers Foundation.

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