Pulling the Trigger on Bonds

My last two columns have focused on what I believe are the best opportunities in the bond market. Based on the emails that I have received, many people want to know how to turn strategy into action. In response, I think it's time to write a piece that focuses on execution.

Before I do that, however, I'd like to touch on value again. Two weeks ago, I said I was worried about the impact of collateralized debt obligations on the high-yield market. After talking to a number of people, I am now less worried. Holders of collateralized debt obligations are not panicking, and are, in fact, still buying. Demand is strong enough that Brian McManus, the chief CDO strategist at Merrill Lynch, says that most CDOs have no trouble placing their rated notes.

With the Fed having eased, and with the CDO sector giving the market a bid, I now believe it is OK for investors to think about junk bonds, as long as it fits their risk profile.

Charter Communications' (CHTR Quote - Cramer on CHTR - Stock Picks) ability last week to issue the largest junk deal in nearly a year is further evidence that there is demand for select names. It's important to remember that defaults will still probably continue to increase this year, so selectivity is important. I would concentrate on finding a fund manager who was able to avoid the telecom disaster of last year.

Now, on to execution. I never owned many bonds in my personal account until last summer, as I was working in the bond market at my old firm. If bonds did well, then I did well, so there was no need to leverage my personal holdings, which consisted primarily of stocks and money market funds. As I made the transition to working on my own, I wanted to have some fixed-income exposure for safety and for income.

When I went to buy bonds for myself, I was stunned at the difference between buying them as an institutional investor and as a retail investor. What I would like to do is share my experiences and the decision-making process as a guide to some of the issues that many of you are facing. The decisions I've made will not be right for everyone, but by pointing out some of the benefits and drawbacks of different choices, I hope you'll be able to construct a portfolio that fits your needs. There is no way that I can cover every situation, but by looking at some of the major issues, we can still come to a pretty good solution.

I've tried to make investing in bonds as simple and cost-effective as possible. Bonds of similar maturity and quality tend to trade at roughly similar yields. Thus, the reward per hour of effort tends to be much greater in the stock market than in the bond market. I'd rather put more of my time into trying to exploit the difference between the price of the stocks of two auto companies rather than their bonds. In bonds, I try to focus on getting the big picture right and concentrate on finding the maturities and sectors that are right for me.

One of the big decisions that people face is whether to buy individual bonds, or to buy a mutual fund that invests in bonds. There are pluses and minuses to either. Your time frame, willingness to do it yourself and desired sector should have an impact on which path you choose.

If you are investing for a certain point in time, say, two to five years, to meet a defined need like a home purchase or college education, it might be better to consider individual bonds that are timed to mature when you need them. If you were to buy a fund, and if interest rates were to rise just before you needed the money, your share price would be down and you might be faced with a funding shortfall. A targeted maturity portfolio allows you the comfort of knowing your money will be there when you need it, as long as you've been able to pick bonds that won't default.

Treasury bonds and agencies fit that bill, though of course they offer lower yields than corporate bonds . To get the higher yields of corporates, you'll need to do enough credit work (or rely on a trusted broker or adviser) to be comfortable that your bonds will be "money good." The trade-off between higher yields and more work is an important one. The lower in quality you go, the more work that must be put into credit analysis. Thus, as you go down in quality, it makes more sense to buy a fund. You get the benefit of professional analysis, and you also get much more diversity, which is relatively cheap in the bond market.

I initially wanted to start buying five- and 10-year Treasury bonds, partly for the reasons that I outlined in an October column and partly to lock in some college funding. After starting that, I planned to start buying corporates for the wide yield advantage they were providing over Treasuries. Because I was moving a fairly substantial portion of my assets, I wanted to do it gradually over time and in many small pieces. That would allow me to average my way in.

In hindsight, I would have made more money by moving all at once, but I didn't want to move 30% of my assets in one shot, only to have it fall victim to something like a surprisingly strong employment number. I wanted to do it using one of my two online brokerage accounts because between them and the three fund families I use, I already have enough paper and complexity in my life.

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