Build up your bond portfolio

Disappointed with your bond funds? It's now cheaper, easier - and possibly safer - to assemble your own fixed-income portfolio.

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By Joe Light, Money Magazine staff reporter

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(Money Magazine) -- There's an old saying that goes, "You make your money in stocks but keep your money in bonds."

It refers to one of the principal reasons many investors stash money in bonds at all times - to keep their portfolios afloat even in a market storm. But if you invested in bond mutual funds in last year's tsunami, you're probably questioning the veracity of this adage. True, your bond funds didn't sink as much as your stock funds did, but they weren't exactly a life preserver, either.

That experience illustrates a key point: Even though bond funds invest in a diversified mix of fixed-income securities, there's nothing fixed about their returns. The value of a bond fund - and the income it generates - will always fluctuate, since it's constantly buying and selling hundreds of securities of varying maturities. That's why bond funds can never guarantee that you won't lose money.

Individual bonds, on the other hand, can - and do - make this pledge. Individual bonds issued by companies, countries, and municipalities are IOUs. While these IOUs can be traded, as long as you hold them till the end of their terms - till their maturity dates - issuers promise to return their face values, no matter what prices they've been selling at.

Sounds great. But until recently many of us had little choice but to go with funds. With the exception of Treasuries, bonds have historically been hard to research and costly to trade, especially for small investors. Fortunately, that's changing. And given that so many bonds are trading at beaten-down prices, it's a great time to think about assembling your own portfolio.

After reading this story you may decide to put together your own mix. Or you might have an adviser assemble one for you. You may even conclude that a fund, because of convenience and professional management, is still the best way to go. In any case, it's important to understand the basics.

Here are the five biggest questions you'll want to answer.

Are individual bonds for me?

Yes, if you have at least $100,000 to invest. It takes bonds from at least 10 issuers to create a diversified portfolio. However, to get decent pricing, you'll need to buy them in blocks of 10 or more. Since bonds are typically issued in $1,000 increments, that means you'll need at least $100,000 just for the fixed-income portion of your portfolio. Anything less and you're better off sticking with a fund.

Yes, if you want a steady stream of income. Say you're a retiree who needs to generate $5,000 a month. You could go with a bond fund that currently yields enough to produce that payout. But over time, as the manager sells current holdings and buys new ones, the portfolio's average yield will sway - and could fall short of your target. With individual bonds you can lock in precise payments for a definite length of time.

Yes, if you're investing for a specific period. Unlike funds, individual bonds mature on a given date. This makes them ideal if you know you'll need a set amount of money at some point in the future - say, for your kid's college education.

What should I invest in?

Forget regular Treasuries for now. Yes, they're the safest bonds in the world, because they're backed by the U.S. government, and you can buy them directly, free of commission, at TreasuryDirect.gov. But as fearful investors have raced into Treasuries, prices have soared, pushing down yields. The 10-year note now pays just 3%, vs. about 5% in 2006. That means its yield will be entirely consumed if inflation grows at historical rates.

Ten-year Treasury Inflation-Protected Securities, or TIPS, are yielding even less: 2%. But that's 2% after inflation, making TIPS a better bet. So if you want the peace of mind that comes with investing in Uncle Sam, stick with inflation-protected Treasuries, which you can also buy at TreasuryDirect.

Go with investment-grade corporate bonds. Uncle Sam will never default on his debts, but corporate bond issuers might. To mitigate this credit risk, stick with a mix of high-quality bonds (rated BBB or higher by Standard & Poor's or at least Baa3 by Moody's). Even highly rated investment-grade debt is now yielding three to four percentage points above Treasuries, compared with less than one point in 2006. "There are lots of opportunities here," says James Camp of Eagle Asset Management.

Stay clear of high yield. The riskier the issuer, the more interest its bonds must pay to attract investors. And right now the double-digit yields on non-investment-grade "junk" bonds may be catching your eye. Look away. Default rates of high-yield bonds - rated BB+ or lower by S&P or Ba1 or below by Moody's - are predicted to hit 16% in this recession. Unlike a fund manager who can choose hundreds of bonds to invest in, you can't diversify enough to protect against one bad bond wiping out a huge portion of your portfolio. Also avoid investment-grade debt that's paying more than four points above Treasuries. When high-rated bonds sport junk-like yields, it may mean a downgrade is near, says Hildy Richelson, co-author of Bonds: The Unbeaten Path to Secure Investment Growth.

Buy municipal bonds, but only high-quality issues. Muni bonds - issued by cities and states to raise money for roads, stadiums, and public works - normally yield around 80% of what equivalent Treasuries pay. That's because muni income is exempt from federal and, in some cases, state income taxes.

But because of concerns that municipal budget shortfalls will lead to rising defaults, the highest-quality munis are yielding about the same as Treasuries - even before taxes. For example, 10-year AAA-rated munis are paying 3.3%. That's like earning 4.6% on a Treasury if you're in the 28% tax bracket.

How do I buy a bond?

First, do your homework. Most brokerage sites, including those run by Fidelity, Schwab, and E*Trade, allow you to screen bonds based on yield, maturities, and ratings, among other criteria. So researching bonds has become a lot simpler.

But before you commit to buying, investigate the issuer's health - specifically its ability to pay its debts even in bad times. To do that, look at its so-called debt-to-equity ratio, which is the firm's long-term obligations divided by its net worth. You'll want to check that the issuer's debt-to-equity hasn't been climbing significantly in recent years. That's a sign that its financial cushion to pay back debt is shrinking. You can look up a firm's current and historical ratios at Morningstar.com by typing in the company's ticker, then clicking the Key Ratios tab.

Next, contact your broker. Even in this online world, it's useful to call your broker directly. For instance, if you're trying to buy a bond online, you'll want to know if the security is being sold from the broker's inventory or from another source. It's preferable to buy directly from your brokerage, since it won't hit you with a trading fee. But the firm will charge you if it brokers a sale from another firm's inventory. A typical commission is $1 per bond; in some cases, there's a $10 minimum.

Focus on newly issued bonds. As the graphic above shows, bonds can be purchased when they're newly minted, at a face value of $1,000 a bond ($5,000 for munis), or traded on the secondary market, where prices fluctuate. Though you may not have access to every new issue, financial advisers suggest at least starting your search with newly minted securities. Why? You'll get the same effective yield as you'd earn from bonds on the secondary market, but will pay less for the transaction. That's because brokers make their real money off the spread between the price at which they buy a bond and the price at which they sell. With a new bond there is no spread.

Be willing to negotiate on price. Buying bonds is not a one-click proposition. You have to bargain. Negotiating used to be tough when information on bond sales was hard to come by. But today you can go to Investinginbonds.com and look up the prices on recent trades. If the broker isn't offering the same price that similar investors got - or better - counter-offer.

How do I put together a portfolio?

Diversify your securities. Not only should your portfolio include bonds from 10 issuers - including companies and municipalities - but it should also have exposure to multiple sectors. If you stick with highly rated debt, you'll naturally gain exposure to some companies that tend to do well in a tough economy like health-care firms, consumer staples companies, and utilities.

Diversify your maturities. If you're looking to create a steady stream of income, you'll want to "ladder" your portfolio. Laddering simply means buying bonds that mature in routine intervals, like once every year. By diversifying when each bond comes due, you won't have to reinvest your entire portfolio at the same time - for instance, when rates are low.

How does a ladder work? By buying 10 bonds that mature annually between 2010 and 2019, you can create a portfolio with an average five-year maturity. Five years allows you to earn a solid yield without tying up your money for too long. When your shortest bond matures in 2010, you can just reinvest the proceeds in a new 10-year bond to maintain your portfolio's average maturity.

How do I manage my portfolio?

Hire a pro. You don't have to manage (or even assemble) your portfolio on your own. Several retail brokerages, like Schwab and E*Trade, have programs that will help you run your bond portfolio. Advice on picking bonds is typically free, but if you want them to manage your portfolio, it will cost around 0.5% of your bond assets annually. Many registered investment advisers also specialize in managing bonds for individual investors.

If you DIY, pay close attention. "The biggest mistake I see investors make is that they set up the portfolio, then leave it alone," says Marilyn Cohen, president of the fixed-income investment firm Envision Capital Management. She notes that bond investors must regularly monitor their portfolios to make sure the financial health of their issuers hasn't changed. Plus, once you buy your bonds, you'll start getting regular interest payments, and every year or so some of your bonds will come due. It's up to you to reinvest those funds.

Sure, managing your own bond portfolio takes work - even more so than buy-and-hold stock investing. But in exchange you get what your bond funds could never promise: a money-back guarantee.  To top of page

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