Spray Bear Repellent on Your Portfolio

Physician's Money Digest, March31 2003, Volume 10, Issue 6

With historically low interest rates,fear of war, deficit spending, andthe possibility of inflation, physician-investorsmay be wondering if bondsrepresent a good investment.

Bonds should make up a meaningfulportion of most traditional portfolios. Inaddition to diversification, bonds providea steady stream of income, a significanthedge against bear markets, and assuredamounts of liquidity at each bond's respectivematurity date. Many of our clientswho are either nearing retirement oralready enjoying retirement have as muchas 80% of their portfolios in investment-gradebonds (ie, BBB or better). Still, thereare some risks to owning bonds thatshould not be overlooked.

KNOW LONG-TERM RISKS

Many people don't realize that themain risk in investment-grade bonds isnot the risk of default, but the principalvalue risk caused by rising interest rates. Ifyou purchase long-term bonds now, andthe fed raises rates—a real possibilitygoing forward—your bonds will be worthless on resale than you paid for them.

For example, if you bought bonds at100% value that paid a 6% coupon andneeded to sell them before they maturedat a 93% value, you would be in the unenviableposition of receiving 6% interest,while losing 7% market value. This wouldgive you a total return of -1%, on whichyou would pay federal income taxes of6% interest income received. The longerthe term of the bond, the more risk youface. Being forced to sell long-term bondsin an environment of rising interest rates isnot a desirable position.

Short-term bonds, with maturities of1 to 5 years, don't rise or fall very muchin value. Predictability is the key wordhere, and the strategy that we're after.Long-term bonds, with maturities inexcess of 10 years, move in value 3 to 5times as much as short-term bonds do,but offer interest rates of usually lessthan twice that of short-term bonds.

In the environment that we are forecasting,with interest rates rising and bondprices falling, investors would be better offin medium-quality short-term bonds, payingsomewhat higher rates than high-qualityshort-term bonds, and slightlylower rates than long-term bonds.

The tradeoff of bonds paying somewhatlower interest and holding theirvalue while interest rates are rising is agood one. By staying relatively short term,if you need to sell your bonds prior to thematurity date, you won't subject yourselfto a major loss in market value. In thisenvironment, if there's any chance youmay sell before maturity, stay short.

LADDER BONDS FOR PROFIT

Using a laddering technique protectsyour portfolio when there is a risk of risinginterest rates. A bond ladder is nothingmore than buying bonds in regularly increasingmaturities. Starting with a 1-yearmaturity, you purchase in 1-year incrementsup to 5- or 6-year maturities. Eachyear, as a bond comes due, the investor hasthe choice of spending it or reinvesting theproceeds in bonds at the top of the ladder.If interest rates are rising, you benefit bypurchasing bonds at the current rate.

This technique allows you to keepmaturities short and significantly protectsyour bond portfolio against loss of marketvalue. Because you aren't selling until thebonds mature, there is virtually no risk oflosing principal and you can reinvest innew bonds that pay higher coupon rates.

As a rule of thumb, if you have morethan $100,000 to invest in bonds, considerusing individually selected bonds ratherthan a bond fund. Less than $100,000 willnot allow you to achieve the best marketpricing and will not allow you to be welldiversified. Bonds are usually purchased insums of $25,000 or greater; less than thatamount is considered an "odd lot." Sellersof odd lots are often penalized since thereneeds to be higher per-bond costs toamortize transaction expenses. Rememberthat bond funds never come due. Bondfund prices never find a bottom until ratesstop declining. Bonds maturing do.

Bonds bring a dimension of predictabilitythat many investors need in the currentmarket. Even if another downturnhappens, if you have adequately allocatedyour portfolio with short-term bonds, youwill have repelled the bear in a big way.

Jonathan Krasney is a financialplanner and the president of Krasney Financial, LLC, inBrookside, NJ. He is an expert in personal finance issues forhigh-net-worth individuals and often assists clients in estate planning issues,tax management, bonds, mutual funds, and charitable giving. He has appeared on CNN,CNNfn, and can be seen regularly on CNBC's Power Lunch "Making Your MoneyWork" segment. Mr. Krasney welcomes questions or comments at 888-572-7639 orinfo@krasneyfinancial.com.