Fixed Income Question

A reader left the following question which I will try to answer.

Funny, I've been thinking about bonds for several day's now. Since you bring it up, I have a question. I agree with you that removing bonds from the portfolio misses the point of including bonds. My question has to do with what the mix of bonds should be... How much should be muni, international, government, and corporate? Do you know of a good resource for determining the proper mix? I know that I should lean toward short term in a rising rate environment, it's determining the rest of it that I'm not sure of. Thanks!

This may seem familiar to some readers. Owning individual bonds can be tough because of something called trading friction. Basically small bond positions have large markups and markdowns hidden in the price you get. If your account is large enough to buy $100,000 face value of one bond this becomes less of an issue. That being said owning individual muni's, if you need that part of the market is probably ok. A reader let me know about Nuveen Muni Value (NUV) because it is a closed end fund with no leverage and it yields 5.04%. I have not looked at the fund so I can't vouch for it.

In putting together the fixed income part of the portfolio I take a similar approach as with equities in that I want to capture many different parts of the market in an attempt to reduce volatility that might come from some extreme event or movement. Most of the tools I use all yield between 5.5% and 7% but one or two things yield a little more. I also use a inverse bond fund as a hedge against rising rates.

The first category I'll cover is preferred stocks. A great resource to research these is QuantumOnline. Most accounts have three or four of these. I use mostly, but not only, shorter dated issues. Longer dated issues got hit very hard in the summer of 2003 when rates had that nasty spike. You can easily find quality issues that yield in the low and mid sixes. I would avoid CEFs that owns preferreds, they can be more volatile than individual issues.

I also use very generic government bond or govie/corporate blend funds that do not leverage. These are by far the most conservative tool I use and for the most part yield in the mid fives.

Next is high yield (junk). I use a CEF here as well. High yield bonds tend to react differently than higher quality bonds to a lot of types of stimuli. Statistically speaking very few bonds in this category default, owning a CEF here reduces that element almost to nothing.

I own a convertible bond CEF. Converts, as I have written many times, tend to trade like stocks when the stock is moving up to the conversion price and tend to trade more like bonds if the underlying is going down, away, from the conversion price. CEFs in this category usually yield in the eights and do use leverage. Owning individual issues here can be very difficult.

There are a couple of very low beta MLPs that I use for some clients for income. Be very careful here. Even a low beta MLP will get hit hard if energy prices plummet. I would not buy a fund of MLPs for income, I think these will turn out to be more volatile than most people think.

Foreign bond fund funds usually do well when the dollar falls and I expect they will hold up better if/when US rates go up in the middle and long end of the yield curve.

I've written a lot about CEFs that sell covered calls. My original thought was that these equity funds would trade more like bonds but be a little less interest rate sensitive. These types of funds yield 8% or more. Year to date MCN is up just under 1% while the S+P 500 is down about 3%. So it seems to trade more like a bond but we'll see if it has less interest rate sensitivity in the future.

Lastly, TIPS. I have been considering adding a CEF that is a blend of mostly TIPS and some higher yielding bonds. There are a couple of these out there, I own one personally but still haven't added one to client portfolios. I have written before that I would not buy an open end TIPS fund.

I have the heaviest weightings for clients in preferreds and lower yielding CEFs. Actual percentages depends on the client. Hope that helps.