Classic: Take the Easy Road With Bonds

I really enjoyed answering the “Ask Our Pros” questions at RealMoney.  I answered the following on May 11th, 2005, and would add in Jeff Gundlach and Ed Meigs as active managers:

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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.

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.

Another reason you don’t want to buy bonds, single-issuer bond trusts or preferred stocks on your own is that many of them have funny features that make the yield look really good, but the bonds can be called away in low interest rate environments, leaving you to reinvest in that low interest rate environment. One dirty secret of bonds is that the excess yield inherent in callable bonds and residential mortgage-backed securities on average does not compensate for the call risk. Only a few experts win that game, and you likely are not one of them.

Finally, my word on bond funds: There are very few managers worth paying up for. Maybe Dan Fuss at Loomis Sayles, Bill Gross at Pimco and a few other, more obscure managers that I am less certain are worth paying up for. The only guarantee in bond funds is that low expenses win in the long run, so I’d go to Vanguard. Performance advantages are fleeting, and tend to revert to the mean, but expense advantages are permanent. Vanguard’s bond funds usually are in the top half each year; repeating that for 10 years makes them top decile.

So don’t take the hard road. I’d go to Vanguard and use their Total Bond Market index fund. Utterly unsexy, but a winner. The only place where Vanguard lacks is international bond funds; it has none. For that, if I want diversity, I go to T. Rowe Price, or buy a closed-end fund that doesn’t hedge currencies at a discount.

How much to invest in bonds? Consult your financial planner. This factor varies so much, it’s all over the map. The right proportion of bond investment depends on market conditions, investment horizon, your personal life factors, wealth level, risk aversion, etc. My experience is that most people are unbalanced in their asset mixes — too much is in stocks or too much is in bonds. The best default mix might be Ben Graham’s 50/50, or the pension mix of 60% stocks, 40% bonds. These are both very robust strategies, but again, what is best for you depends on your personal situation.

I have to say, from the business side of the desk, I really loved managing a multibillion-dollar bond portfolio. I really did well at it, but the best part about it was interacting with my brokers, who all were stupendous to work with. I find that running equities is antiseptic, particularly as an analyst who has an exceptionally competent trader to execute his decisions. Running bonds is colorful because of the human interaction and all of the games that can arise from that. I learned how to haggle in the bond market, and for a nerd like me, becoming good at that was a surprise. Would I want to manage bonds again? Yes. It was fun.