How to use bonds to cut investment risk

Article from MSN Money

When paired with stocks, bonds diminish risk without crimping long-run returns. Forget fancy formulas -- 60/40 or 70/30 works for just about everybody. Here’s how to get started.

For the vast majority of investors, bonds serve a single, overriding role -- as ballast. True, bonds function well for income seekers, and, in the hands of an adept speculator, they can beat the stock market for long stretches. But most importantly, bonds help keep a stock-focused portfolio sturdy -- steadily, predictably sailing toward long-run returns.

Bonds suffered neglect during the 1990s bull market in stocks. Investors parked ever more of their assets in equities, afraid to miss out on the rocket ride. But when the rocket crashed in 2000, stocks-only portfolios shattered. Better-diversified accounts, however, enjoyed much of the moon shot without the crash landing.

Find the right mix

The first fixed-income question for most investors is, what's the right ratio of bonds to stocks?

Michael Holland, who manages the Holland Balanced fund (HOLBX), strongly advocates a 60/40 ratio of stocks to bond for most investors. With this mix, investors can expect 80% of the stock market's long-run return but with a truly moderate level of volatility.

Holland's fund offers something of a test lab -- and wouldn't be hard to emulate. It's split almost exactly 60/40, with the stock component spread over about 20 blue chips and the bond portion almost exclusively in Treasurys, the rock-solid bonds issued by the U.S. government. (Holland's tiny fund had only $50 million under management in early 2003. His marketing consists of one Wall Street Journal ad once a year, plus annual ads in the magazines Harvard and Nantucket. He says his 2,500 or so holders never sell.)

A $10,000 deposit in Holland's fund in April 1997 (its inception) was worth $11,711 in January 2003. An identical deployment in the Vanguard 500 Index fund (VFINX) amounted to $12,162. In 2001, when the S&P 500 ($INX) index skidded 11.1%, Holland's balanced fund edged down just 0.2%.

Interested in even more security than the Holland formula offers? The minimum-risk allocation mix probably is 80% fixed-income, 20% stock, according to Alan Gayle, senior investment strategist for Trusco Capital Management. Gayle oversees investment policy for a broad array of mutual funds, and he helps manage the $575 million STI Classic Growth and Income fund (CRVAX). In his view, a 100% bond allocation would be ill-advised, even for the most risk-averse investor, as bonds can suffer lengthy bear markets of their own.

Bond allocation guidelines

Whatever your asset-allocation goal, Gayle offers some guidelines for splitting up the bond portion:

Start with 25% or more in bonds with as little default risk as possible: Treasurys, inflation-indexed Treasurys or municipal bonds.

Then add bond funds with "economic exposure," such as those focused on highly rated corporate bonds. These usually outperform Treasurys when the economy heats up. (A fund offers the diversification few investors achieve with individual corporate bonds.)

Don't neglect junk bonds. They deserve at least 10% of your bond investment. They correlate more closely with equities than with fixed income, and their higher yields can compensate when Treasury yields are low. Funds are the only way to play the high-yield market.

The safest bond

The safest choice of ballast material for your portfolio is Treasurys (and inflation-protected Treasurys). Only rarely do Treasurys offer the fixed-income world's biggest returns. But their issuer -- Uncle Sam -- won't be going bankrupt. Here are the best ways to buy them:

Directly from the government. The U.S. Department of the Treasury has Web site called TreasuryDirect that allows for the purchase of Treasurys. It's easily accessible to individual investors, and Treasurys can be bought at auction at no fee.

Mutual funds. There are relatively few Treasurys-only mutual funds. But some exchange-traded funds have emerged that are modeled on Treasury indexes. (Exchange-traded funds, or ETFs, are essentially baskets of actual securities that are broken into pieces for individual investors to buy. ETFs offer low fees and have certain tax advantages.) In summer 2002, Barclays Global Advisors launched three ETFs pegged to four Lehman Brothers Treasury indexes: the Lehman 1-3 year Treasury (SHY, news, msgs), Lehman 7-10 year Treasury (IEF, news, msgs) and Lehman 20+ year Treasury (TLT, news, msgs).

Government bond funds. The most common Treasury proxy is the ubiquitous "government bond fund," which usually amalgamates Treasurys, highly rated agency debt (from the Federal Home Loan Bank, Ginnie Mae and other entities) and even short-term corporate bonds. Vanguard, T. Rowe Price and PIMCO offer government funds of various durations with excellent track records. (Just be careful which class of fund shares you buy -- sales loads can be high, particularly from PIMCO.)

Simplicity is the primary advantage of these funds. Writing a check to a fund company takes less effort than buying individual bonds and can, for some investors, be worth a small annual fee. Many financial planners scorn government-bond funds, though. The problem? Few bond funds feature a single maturity date. Most managers buy and sell to take profits or pounce on perceived bargains. The only way to guarantee stability of principal is to buy individual bonds and hold them to maturity. (An exception: American Century offers a series of "target maturity" funds that hold only bonds that mature in a single year. When held until maturity, these funds closely mirror the experience of buying individual securities.)

The municipal alternative

While Treasurys tend to be the first bond category beginning investors consider, they aren't always the best option. Treasurys perform best in tax-deferred accounts, since Uncle Sam treats interest payments as regular income. And they can melt in value during periods of inflation.

One alternative: high-rated municipal bonds. These promise Treasury-like safety from default as well as important tax breaks. Buy bonds issued by municipalities in your home state, and you usually dodge federal, state and local taxes -- the "triple tax free" promise that makes munis favored income vehicles for the well heeled.

Even for the rest of us, munis make good sense. Assume you're in a hypothetical 30% federal tax bracket. A muni yielding 5% earns just as much -- after federal taxes -- as a Treasury yielding more than 7%. In early 2003, 7% Treasurys existed only in the recollections of old-timers.

"If someone were to get a fixed-income portfolio and their money were sufficient, I would think that they should own outright some high-quality municipal bonds," says Trusco's Gayle. He recommends insured or triple-A-rated general-obligation bonds.

The main problem with munis is getting your hands on them. A round lot of any particular bond goes for as much as $250,000. Buy less and you pay a higher markup. Financial planners see $100,000 as just about the smallest allocation that can go into individual munis.

Yes, you can go the mutual fund route, as muni funds accept smaller amounts. But be careful to know exactly what you're buying. "If they're going to own mutual funds, then they need to be examining the prospectus to see what the quality parameters are," Gayle says.

MSN Money offers tools for just such an examination. Start with our Top Performers screens to find consistently performing muni funds focused on your home state. Seek a low expense ratio -- it can be as little as a quarter percentage point -- and a long-tenured manager.

Tips on TIPS

While munis guard your interest from the tax man, TIPS fend off income investors' other bugaboo: inflation. Treasury Inflation-Protected Securities pay a small coupon yearly, plus their principal value is adjusted once a year to match changes in the Consumer Price Index. TIPS are cheapest when the economy is heading south and no one fears inflation. Traders hate them, but buy-and-hold investors find their inflation insurance comforting.

"It's possible sometime in our lifetime we'll have inflation again bite us in the butt," says Holland.

The downside: TIPS present tax problems. The inflation adjustment counts as income in the year it is made, even though investors don't pocket the principal until maturity. Also, TIPS are auctioned less frequently than other Treasurys. The government promises a new 10-year TIPS each July, and it reopens them for new investment in October and January.

In general, TIPS and munis move in sway with Treasurys. They make equally good ballast to counteract stock gyrations.

Reaching for yield

Money managers and investment planners debate the wisdom of sinking your entire bond allocation in low-yielding (but rock-solid) Treasurys and munis. Holland wouldn't have it any other way. But Richard Lehmann, publisher of the Forbes/Lehmann Income Securities Investor newsletter, recommends mixing it up.

Corporate bonds, junk, mortgage-backeds, mid-tier municipals and a host of other higher-yielding options abound. But it's hard or impossible for individuals to buy many of them. Minimum investments are large, and individual bonds carry exponentially more risk than a diversified bunch. Moreover, expensive research tools give professional traders huge advantages in valuing each bond's unique features -- maturity, coupon, call dates, credit rating and more. And unlike stocks, few bonds aside from Treasurys have easily accessible price histories. Fewer than 100 corporate bonds are listed on the New York Stock Exchange.

"In fixed-income investing, it is much more complicated to select the instrument you want to invest in," Lehmann says. "With common stock, everything is the same."

A typical investor seeking diversification and total return has two realistic options: Buy mutual funds or make fixed income a hobby and find a guru like Lehmann to follow. Funds encapsulate every segment of the bond market into bite-size portions, though at the price of a management fee and without a guarantee of principal. Bond newsletter writers, among whom Lehmann is the dean, make specific recommendations but leave the portfolio in your hands.

For simplicity, Trusco's Gayle suggests sticking with highly rated corporate-bond funds. He guides individual investors away from mortgage-backeds because their boom and bust cycles are less predictable. He and Holland offer a few basic rules to guide bond-fund purchases:

Pick a sensible credit-rating range. Moody's and Standard & Poor's use slightly different scales that appraise corporate bonds from D (in default) to triple-A (zero perceived default risk). Enter a fund's five-letter symbol in the MSN Money quote box, then click Fund Portfolio in the left-hand navigation -- the fund's average credit rating is the first data point you'll see. The PIMCO Total Return Fund (PTTAX), managed with great success by the legendary Bill Gross, has an average rating of double-A.

Pick a duration that doesn't make you sweat. Each bond fund has an average duration, related to (but different than) the average maturity of the fund's holdings. Duration essentially measures a bond's sensitivity to interest rates. It's given in years. PIMCO Total Return in early 2003 had an average duration of 4.4 years -- a middling number. A smaller figure offers greater defense against rising interest rates; a larger number offers more market sensitivity to declining interest rates.

Follow the other usual guidelines for buying funds. That means low fees, a reputable manager and a solid track record.

Regular maintenance pays off

Stocks have no ceiling. Theoretically, share prices can rise unceasingly so long as earnings expectations keep growing. But bonds run in cycles. They have ceilings -- and floors. Yields don't fall to zero or rise to infinity.

For that reason, they need to be treated differently than stocks. Watch a few different bond categories over time and you'll quickly learn to capitalize on their individual peaks and troughs. In early 2003, for instance, Treasurys looked very pricey, high-grade corporates were mending and junk bonds had come back from their 2002 collapse. Munis weren't sure what to make of a proposed cut in dividend taxes, which might lower their status among income investors.

But even before you harmonize with the bond universe, you can employ a mechanistic approach. Strike that stocks/bonds mix and rebalance to it once a year. Employ a similar approach with your bond holdings. Pare back winners and reallocate more to losers.

"It's very important not to take your eye off of the goal line," Gayle says.

You'll also have to decide what to do with the interest checks. In tax-deferred portfolios, they're best reinvested to avoid steep penalties.

In non-retirement holdings, income reinvestment helps build up bond allocations more quickly -- though you must weigh the costs and benefits. Interest is taxable in the year it's earned, regardless of whether it's reinvested. And taking income from bonds actually helps cut investment risk even further. If they get ploughed back in to principal, those interest checks are in play. Alternatively, they are beyond the market's reach once they go into cash or get used for everyday expenses.

At the time of original publication, Scott Gerlach owned or controlled shares in the following securities mentioned in this article: PIMCO Total Return.

Article from MSN Money

Banks Face Funding Stress

European Institutions Resort to Potentially Risky Swaps to Generate Liquidity

Article from The Wall Street Journal
By DAVID ENRICH

LONDON—European banks, increasingly concerned about their ability to access funding, are devising complex and potentially risky new deals that enable them to continue borrowing from the European Central Bank.

The banks' maneuvers, which include behind-the-scenes swapping of assets among financial institutions, could heighten risk across Europe's already fragile financial system, say some senior industry officials and regulators.

They also are a sign that struggling banks across Europe are preparing for a period of prolonged reliance on financial lifelines from the ECB. The Continent's intensifying financial crisis has made it difficult for many banks to obtain funding from customary market sources.

Some banks are exhausting their supplies of assets—such as European government bonds and certain types of asset-backed securities—that the ECB accepts as collateral and that the banks haven't already committed to other uses, according to bankers and analysts. Others are scrambling to stockpile such assets to comfort analysts and investors worried about the banks' abilities to weather a long-term freeze in bank-funding markets.

Meanwhile, signs of stress continued to bubble up in the European financial system. ECB purchases of Italian and other euro-zone government bonds on Wednesday largely failed to halt the sell-off of struggling euro nations' debt.

And some European bank customers are balking at doing business with the banks. Norfolk Southern Corp. has decided not to use any European banks to refinance a credit line out of concern about the banks' future health, according to people familiar with the matter.

To ensure that their access to ECB loans continues, the banks are entering into a variety of complex transactions with other financial institutions to come up with billions of euros worth of assets that they can pledge as collateral to secure ECB loans, according to bankers and industry officials.

Some regulators and bankers are worried. By transferring potentially risky assets among a wide range of institutions, the so-called liquidity swaps have the potential to "create a transmission mechanism by which systemic risk across the financial system may be exacerbated," the U.K.'s Financial Services Authority warned in a July consultation paper.

Last month, the Bank of England hosted a meeting for a small group of risk officers from major international banks. When the conversation touched on liquidity swaps, a number of executives, including a senior UBS AG executive, voiced similar concerns as the Financial Services Authority, according to people familiar with the matter.

The scramble for ECB-eligible collateral highlights the tenuous state of Europe's banking industry. Traditional sources of bank funding, including institutional investors and fellow banks, have largely fled amid concerns that many lenders are sitting on huge piles of risky government bonds and loans to shaky borrowers.

That has left a funding vacuum that a growing group of banks are filling with loans from the ECB.

In the increasingly popular liquidity swap, banks transfer illiquid assets such as non-investment-grade loans to corporations or to finance public-infrastructure projects—and which aren't eligible to serve as collateral for ECB loans—to investment banks or insurance companies.

In return, the investment banks or insurers provide government bonds or other liquid assets that the original bank can use as collateral to secure loans from the ECB. The investment banks apply a discount to the assets they are receiving—shielding them from some potential losses—and receive commissions on the trades.

Euro-zone peripheral bonds fell back after the European Central Bank stepped back into the market to provide support. But how long can the ECB continue doing this and will it continue working? And is it all too late for Greece?

A number of French, Italian and other European banks, including bailed-out Franco-Belgian lender Dexia SA, recently have entered into such transactions, according to people familiar with the matter.

"It's a way to improve your liquidity and to get liquid some assets that are not liquid," said a senior Dexia executive, who says he has crafted billions of euros of such trades in recent months.

The Frankfurt-based central bank accepts a wide variety of assets as loan collateral, including European sovereign bonds, securities comprised of mortgages and other assets, and "covered bonds" backed by loans and other assets on banks' balance sheets.

The ECB's extensive loans to banks have put its own balance sheet at risk, many analysts say. Partly to protect banks in the periphery, ECB officials suspended rules that had confined the central bank to only accepting investment-grade government bonds. As a result, the ECB now holds junk-rated Greek, Irish and Portuguese bonds.

ECB officials insist their balance sheet is safe. The central bank has taken steps to protect itself, including doubling its capital base.

At the end of October, euro-zone banks had borrowed a total of nearly €600 billion ($811 billion) from the ECB, up from €495 billion at the start of the year, according to data from individual central banks. Among the biggest borrowers are banks in France and Italy, with each country's sector having borrowed a total of more than €100 billion at the end of September, up sharply from prior months.

At giant French bank Crédit Agricole SA, executives said last week that they are taking steps to "rapidly increase" their holdings of assets that can be pledged as collateral. Among those actions are bundling together large numbers of mortgages and other loans into asset-backed securities that the ECB will accept, according to a person familiar with the matter.

Some executives are pleading with the ECB to accept a wider array of assets. "In the name of the smallest Italian banks, I will ask [the ECB] to look into the possibility to broaden access to ECB liquidity by expanding the type of collateral offered," UniCredit SpA Chief Executive Federico Ghizzoni told an Italian newspaper Wednesday.

For months, European banks have been pursuing innovative strategies to address their real or perceived collateral shortages. Several Greek banks, for example, recently issued government-backed bonds that analysts say are likely to serve as collateral for ECB borrowings.

The use of the swaps transactions is becoming increasingly prevalent, bankers say. "They are becoming more frequent because in this environment, you want to have additional insurance policies," said a top executive at a major European bank, who has worked on the deals.

—Aaron Lucchetti, Geoffrey T. Smith and Brian Blackstone contributed to this article.

Write to David Enrich at david.enrich@wsj.com

Article from The Wall Street Journal

Why Munis Are Worth a Look

Article from The Wall Street Journal

Municipal bonds faced two key tests this past week—and came out looking sturdy.

The first was a spike in Italian government bond yields that culminated Wednesday with a global flight from risky assets. Muni prices rose, a sign that investors ran toward them, not away from them.

The second was Thursday's bankruptcy filing by Jefferson County, Ala., the largest municipal bust ever. It was expected, but it could have gotten investors thinking that Jefferson was a harbinger rather than an isolated failing. Instead, muni prices held firm.

"Municipals have held on to their place as the second-safest investment in America behind Treasury bonds," says Greg Serbe of Lebenthal Asset Management in New York.

That No. 2 position might be a blessing for yield hunters, because ravenous demand for Treasurys has cut their yields, which move in the opposite direction of price, to a pittance. That has left muni yields looking high by comparison.

On Thursday, 10-year triple-A munis yielded 2.54%, versus 1.97% for the 10-year Treasury. Before the 2008 financial crisis, it was rare for munis to pay more than comparable Treasurys, Mr. Serbe says.

Municipals compare well against corporate bonds, too. Companies must prosper to pay what they owe whereas many munis are backed by the ability to tax. Most munis escape federal taxes and some avoid state taxes, too. They're often a good deal for investors with high tax rates, but the Treasury yield squeeze has left munis with broader appeal.

For an investor who pays 25% in income taxes, the 10-year AAA muni yield is akin to getting 3.4% on a taxable bond—a percentage point more than the highest-quality 10-year corporate bonds pay.

Investors can get even higher yields by picking bonds with lower credit ratings or longer maturities. Someone who expects the economy to get better should buy shorter bonds (around five years) with lower credit ratings (say, double-A-minus instead of triple-A), says Kathy Jones, a fixed-income strategist at Charles Schwab.

As growth resumes, the issuer will benefit from higher tax receipts, and if interest rates move higher, the investor will be able to buy a new bond with a better rate when the old one matures.

An investor who expects the economy to get worse should favor longer bonds (20 years) with high credit ratings, Ms. Jones says. The issuer will be able to weather the downturn, and the rate will prove attractive if policy makers keep core interest rates low for years to come. For the investor who doesn't know whether the economy will get better or worse (roughly all of them), a blend of these two approaches is best, Ms. Jones says.

The key, of course, is picking the right bonds. Some municipalities face budget shortages in the near-term. Others assume unrealistically high returns in pension accounts for their workers, a tactic that lets them set aside less money today but could leave them short years from now, says Robert Novy-Marx, a finance professor at the University of Rochester.

There is another risk to be wary of: a "super-downgrade." Because the big ratings firms—Standard & Poor's, Moody's and Fitch Ratings—review their muni ratings only periodically, there is a chance that they can miss a city's rapid deterioration and then downgrade its bonds by several notches in one swoop, which could cause a steep selloff. It happens only rarely, but owners of individual bonds should be aware of the possibility.

So how to pick munis now? The first step is to consult with financial advisers who specialize in them and understand the risks. Investors should also make use of emma.msrb.org, a website run by the Municipal Securities Rulemaking Board, where they can look up issuer financial information and see what other buyers have recently paid for bonds.

Matt Fabian of Municipal Market Advisors, a Concord, Mass., consultancy, points to the New York City Transitional Finance Authority's 20-year bonds, rated triple-A ("extremely strong") by Standard & Poor's, as a long and safe issue of the sort Ms. Jones cites. The 20-year bonds can be repaid early (or "called") in 10 years. Their "yield to call" is 3.92%.

For a shorter bond with a slightly lower rating, the Allegheny County Hospital Development Authority of Pennsylvania, rated double-A-minus ("very strong"), has five-year bonds that yield 2.14%. Inexperienced bond buyers should stick with double-A-minus and higher ratings, Mr. Fabian says.

Investors looking for broad muni exposure can find it in bond funds. The first choice is whether to use a state-specific portfolio for maximum tax benefits or a national one for the broadest diversification.

"For residents in high-tax states like New York and California, it's hard to beat state funds, but others should stick with national funds," says Jeff Tjornehoj, an analyst at Lipper.

Don't just look for top performers with low fees; consider volatility as well, Mr. Tjornehoj says. Also, funds might be a good bet for investors who want the high yields that lower credit ratings bring but need diversification to reduce risk.

For investors who want longer-dated bonds, Mr. Tjornehoj likes the USAA Tax Exempt Long-Term Bond fund, which ranks in the top 14% of funds by performance over the past three years. Its average credit quality is triple-B and its average effective maturity is 17 years. It has a yield of 4.67%, and costs $47 a year per $10,000 invested.

For shorter bonds, the Vanguard High-Yield Tax-Exempt fund has an average effective yield of 11 years. "High yield" is usually synonymous with "junk," but less than 10% of the fund's holdings are junk bonds, or ones rated below triple-B. The average portfolio quality is triple-B, the yield is 4.41%, and Mr. Tjornehoj says the fund ranks in the top quarter of its peers for performance over the past three, 10 and 15 years. It costs $20 per $10,000 invested.

For exchange-traded fund buyers, Mr. Tjornehoj recommends Market Vectors Long Municipal Index, which yields 4.51%, and PowerShares Insured National Municipal Bond Portfolio, which yields 4.59%. Don't let the name of the latter fund mislead. The municipal insurance business is in sharp decline due to the loss of triple-A credit ratings among insurers. Investors now price bonds as if the insurance didn't exist, Mr. Fabian says.

"It means you have to pay closer attention to the finances of issuers," he says, "but it also means there are wide differences in yields and plenty of bargains for investors who know how to find them."

—Jack Hough is a columnist at SmartMoney.com. Email: jack.hough@dowjones.com