It's not for everyone, but the bond market is becoming more accessible to small investors and can provide ways to diversify your portfolio.
Let's not beat around the bush: Bonds aren't the sexiest asset category out there. And that's especially true when the stock market is on a tear. Sexy or not, bonds can be a smart idea for investors. On Nov. 8, Standard & Poor's strategists recommended that investors increase their exposure to bonds to 25% of their portfolio to hedge against potentially lackluster economic growth next year.
Investing in bonds can be tricky and the jargon—terms like duration, spread, and coupon—sounds obscure to the uninitiated. But with bonds becoming more accessible to small investors, it's a good time to take a look at some ways to invest. Plus, investment pros say it's smart for portfolios to have some exposure to bonds.
One caveat: Fixed-income markets remain less transparent and liquid than those for stocks. With those factors in mind, this week's Five for the Money offers a few tips for inexperienced bond buyers. Introduction to Bond Terminology
1. Do your homework
Smart stock investors know about a company, its market, and how it stacks up against the competition. The same is true for corporate bonds, but it also requires a more thorough analysis of the company's ability to pay back debt. On the other hand, when investing in Treasury bonds, it's useful to have a strong working picture of the economy and its future. Treasury bond prices move inversely to interest rates, and tend to be affected by a wide swath of financial data.
The indicators that should be on bond investors' radars include, but are not limited to, housing starts, inflation measures, movements in the commodities markets, and employment figures. Alexander Sedgwick, the associate director of capital markets research at SNL Financial, says that "the effect that those have in aggregate on interest rates definitely affects fixed-income securities."
Investors should also keep in mind that the more long term their bonds are, the more exposed they will be to interest rate fluctuations. Short-term bonds are probably best for investors just dipping a toe in the market.
Another important thing to keep in mind: tax considerations. Treasury and municipal bond issues have different tax-exempt features. (Interest on corporate bonds is generally fully taxable.) Before venturing into the market, investors should familiarize themselves with some of the options and terminology; one good resource is TreasuryDirect.gov.
2. Let someone else do the work
The bond markets are somewhat more navigable than they used to be, but novice investors looking to diversify their portfolio are probably best off using a preexisting investing instrument like an exchange-traded fund (ETF) or mutual fund. Michael Garry, managing member of Yardley Wealth Management, suggests the iShares Lehman Aggregate Bond Fund (AGG) ETF or the Vanguard Intermediate-Term Investment-Grade mutual fund (VFICX). (He has clients with positions in both.)
These kinds of funds provide diversification and cost less than it would take to establish a bond portfolio, and they don't demand a high-level of familiarity with bond-market arcana. With AGG, Garry says it's possible to "have a bond portfolio with the same dividend, yield, maturity and credit rating as the Lehman Aggregate bond index." And it requires about as much energy as buying some shares of stock.
3. Take some TIPS
One part of the bond market worth exploring is Treasury-Inflation Protected Securities, more commonly known as TIPS. By linking the principal to the consumer price index, these investments rise with inflation, protecting the investor from rising prices and complementing other bond holdings.
"Treasury inflation protected bonds should be part of everybody's bond portfolio," says Russell Wild, author of the forthcoming book Bond Investing for Dummies. He says a "very rough" rule of thumb is for TIPS to amount to a third of a portfolio's bond holdings. TIPS are "a nice complement to other bonds because they tend not to correlate" to other bonds in their price movements. Conveniently, the ETF iShares Lehman TIPS Bond Fund (TIP) is an easy way to get into the market.
More on the basics of Bonds
4. Diversify
"Diversifying is as important in fixed incomes as in equities," says Bill Larkin, head of fixed-income securities at Cabot Money Management. For bond investors with sufficient capital, this means allocating parts of their portfolios to corporate and government bonds as well as spreading out assets to bonds of different maturity dates. One strategy he suggests: a bond "ladder"—a grouping of bonds with different maturity dates.
Arranged properly, ladders can also give investors more freedom to adjust the cash their portfolio generates than if they made a larger investment in fewer bonds. A ladder can also protect investors from some of the vagaries of interest rates. "Nobody knows where interest rates are going to go," Larkin says. More on Buying, Selling and Trading Bonds.
5. Know your needs
Bond investing doesn't fit everyone's investment priorities. "The nice thing about fixed income is that you can get into a position where you can meet your income needs while keeping your principal. That's a win-win," Larkin says. But younger investors and others who do not need to live off their interest income may not want as much of their portfolio in bonds.
By contrast, stocks may be more appropriate for young people who don't plan to dip into their investments for years or decades. The right bond exposure could also depend on factors like family status, income stability, or anything else one considers when investing. But as "something that zigs when the rest of your portfolio zags," Russell Wild, the author, says "bonds really are the best hedge to a primarily stock portfolio."
More on Bond Features
Halperin is a reporter for BusinessWeek.com in New York.
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