Sivy on Stocks

How to buy bonds
But bonds sometimes outperform, and proper use of income investments can boost your overall returns.
August 18, 2004: 10:10 AM EDT

NEW YORK (CNN/Money) - Even if you're primarily a growth stock investor, you shouldn't neglect bonds. In fact, there's a strong case for keeping as much as 25 percent of your portfolio in an assortment of fixed-income investments. Such investments will greatly limit your losses in a market decline. And with that safety net, you can afford to invest some of your money more aggressively, which can actually end up boosting your overall profits.

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On average, Treasury bonds have returned only 5 percent to 6 percent annually over the past 75 years, compared with almost 12 percent for the stocks in the S&P 500.

But those long-term averages obscure the fact that bonds sometimes beat equities. When the stock market is overvalued and interest rates are poised to fall because of a slowing economy, bonds can return a lot more than 6 percent -- and outpace stocks.

Since the current recovery is still in its initial stage and interest rates are likely to rise further, long-term Treasuries are not the most timely investments. But there are other income investments that can serve to balance your portfolio. Here's a look at the full range of 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 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, yields on some municipals have been close to those of Treasuries 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 as much as 8 percent. 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 you're looking for, the chief question is whether to buy them directly or through mutual funds. Since fund expenses can be killers, one 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, consider direct purchases through your brokerage account.  Top of page

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