Ask Our Pros: Take the Easy Road With Bonds

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Reader:

Can someone explain bonds, tax-free vs. taxable? What are some of the strategies that you use to purchase bonds, and what percentage of your portfolio typically should be in bond funds?

-- A.A.

David Merkel:

Here is my simple advice for retail bond buyers:

Bonds are promises, from various entities, to pay back the money that you lent, plus interest. Most bonds are taxable. A few, like U.S. Treasury bonds, are exempt from state taxes, while many of the bonds of municipalities are exempt from federal taxes, state taxes (usually if the municipality is in your state) and city taxes (usually if it's the city you live in).

With respect to taxability, what is best to buy depends on your marginal tax bracket. The higher your tax bracket, in general, the more municipal bonds can help. Beyond that, it is worthwhile to compare the after-tax yields on taxable and nontaxable bonds with equivalent risk. (As always, please be sure to check with a qualified tax professional for advice on your specific information.)

Now for the controversial bits. In general, I don't recommend that individuals buy individual bonds, unless you are buying Treasury bonds and are following a simple strategy like a ladder.

A ladder is a set of bonds that mature sequentially. Say the ladder is five years long; each fifth of the bond money would be invested one, two, three, four and five years out. Each year, you would take the money from the maturing bond and buy a new bond five years out. Many bond managers pooh-pooh ladders because they think they can beat the performance of a ladder. But a ladder is the most robust bond strategy out there, period. I believe it gives the best return for the risk, particularly given the possibility of shifts in inflation, yield-curve twists, etc. But a bond manager can't get paid for running a ladder.

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There are other reasons for avoiding individual bonds: Bond dealers often rip off retail investors. I have stories, but they'll have to wait for another day. Liquidity for retail investors is generally poor. Most of the bonds pitched to retail investors will be new issues, which aren't necessarily the best bonds to buy; they just happen to be the bonds most available at a given moment. This is particularly true of municipal bonds. If you don't believe me, read Joe Mysak's column on Bloomberg for a while. The municipal market is a place you don't want to go without an adviser.

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At time of publication, Merkel and/or his fund was long Vanguard Inflation-Protected Securities fund, though positions may change at any time.

David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.