In the second part of my series on income investing, I discussed the role that common stocks can play in an income investor’s portfolio. But stocks aren’t the only game in town. Bonds are also an important component of any diversified income-focused portfolio.To see a list of high yielding CDs go here.
When it comes to investing in bonds, my preference is to create a diversified portfolio of individual bonds with the intention of holding those bonds to maturity. I might not always hold the bonds to maturity. But the original intention is to do so. Nowadays, commissions and minimum purchase requirements are low enough that a few hundred thousand dollars should be sufficient to build a stable portfolio of individual bonds providing a real, after-tax yield, without assuming an unreasonable amount of credit risk. Some investors may scoff at the notion of realizing a positive inflation-adjusted, after-tax yield in today’s interest-rate environment. But just because that is difficult to achieve in one part of the bond market (Treasuries, for example) does not mean it can’t be found in other parts (corporate bonds and municipal bonds, for example).
Perhaps the biggest reason I prefer individual bonds over bond funds is because absent a default by the issuer, the bond will mature at 100 cents on the dollar. The same cannot be said for most (but not all) bond funds. The additional predictability that principal protection in the form of holding to maturity brings for portfolio planning purposes is something I find quite compelling. Other reasons I tend to favor individual bond investing over purchasing bond funds is the ability to manage which companies you have exposure to and the ability to manage the maturity profile of the portfolio.
If you decide to go the bond fund route, you will have the choice of investing in defined-maturity funds (not that many currently available) or more traditional funds. Defined-maturity funds are supposed to give investors access to a diversified portfolio of bonds while also having a set maturity date, like an individual bond does. Traditional bond funds do not have defined maturities and therefore have more interest rate risk over extended periods of time. Additionally, traditional bond funds tend to maintain relatively constant durations, whereas individual bonds and defined-maturity funds have declining durations over time.
Although I am not a huge fan of bond funds, I can think of two reasons why I might purchase one: First, if I want exposure to a particular part of the bond market but am uncomfortable buying individual bonds in or unable to adequately diversify in that part of the market. Second, if I can purchase a fund with a low/short duration at an attractive price (enough to provide what I consider a margin of safety). Other than that, I am generally not interested in using bond funds to build fixed-income exposure in my portfolio.
In order to maintain sufficient principal protection in the income-focused investor’s portfolio, an allocation to bonds is prudent. The allocation need not necessarily be focused on any one part of the market (Treasures, corporates, munis, sovereigns, etc.). All of us will have different preferences and different allocations. But the one thing that should remain constant across all types of investors is that when building a diversified bond allocation within an income-focused portfolio, the importance of obtaining an inflation-adjusted, after-tax yield should not be understated.
Investors using bonds to grow their portfolios can reinvest that inflation-adjusted, after-tax income into more securities with real yields, thereby maintaining consistently high returns from their bond allocations (the word “high” is relative to the asset class under discussion). On the other hand, investors living off their portfolios need real yields in order to secure returns that would help slow the pace of withdrawals from their accounts or buy them time before withdrawals become necessary.
Finally, as I mentioned in the “The Role Stocks Play in an Income Investor’s Portfolio,” “While it has been historically true that stocks outperform other asset classes over very long periods of time, it is important to remember that each of us has very defined time horizons.” Furthermore, when thinking through how much of your income-focused portfolio to allocate to bonds versus stocks, keep in mind that each of us “runs the risk of growing old at an unfortunate time in stock market history. How much you are willing to risk that your time horizon won’t correspond with an unfortunate time in stock market history will help shape your allocation” within your income-focused portfolio.
In the final article of this series, I will discuss the “other” securities thus far not mentioned that could play a role in an income-focused portfolio.
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