As Dow soars, don't give up on bonds just yet
Long term, bonds still make sense in any portfolio. Here's what to consider now.
from the May 21, 2007 edition
Page 3 of 4
Mix and match. Many experts say diversification is just as important among bonds as it is among stocks.
Mr. Berry of Morningstar says a handful of broad-based funds stand out as possible core holdings. These include Metropolitan West Total Return, Dodge & Cox Income, and Harbor Bond. He also points to index funds designed to mirror the US bond market from Treasuries to corporate bonds: Vanguard Total Bond Market and Fidelity US Bond Index.
What if you're worried that interest rates will rise in the years ahead, due to inflation or falling foreign demand for US debt? One safety valve is bond funds with a shorter time horizon, such as Fidelity Short-Term Bond. A surer protection would be bonds whose returns are pegged to the inflation rate. These include the government's Treasury inflation-protected securities (TIPS) and Series I savings bonds.
Watch your costs. If bonds are paying about 5 percent interest, a mutual fund with an annual expense ratio of 0.3 percent cuts that return to 4.7 percent. Then, if the money is in a taxable account, that could fall again to about 3.5 percent (assuming a 25 percent tax rate). Factor in inflation, and not much is left.
So hunt for funds with no loads and low annual fees. And be wary, experts say, of bond ETFs, which charge a commission every time you buy or sell.
Municipal bonds can shield you from taxes, but the interest rate is often commensurately lower. Right now, municipals look attractively priced for people in the 28 percent tax bracket or higher, Berry says.
But some municipal interest is taxable under the alternative minimum tax. If you might be subject to the AMT, look into AMT-free funds offered by major fund providers.
Cash isn't trash – or king. A money-market fund may seem attractive now, paying interest that isn't that different from many bond funds. Cash won't lose its nominal dollar value as bonds can. But if inflation picks up, money-market yields often lag behind.
"To the extent that cash protects a portfolio against inflation, it does so tardily and after the fact," David Ranson, of H.C. Wainwright & Co. Economics in Hamilton, Mass., writes in a recent analysis.
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