Chasing Fat Bond Yields Can Lead Investors into a World of Hurt

Posted: Mar 27, 2006 4:55 PM

During the dot-com fiasco, millions of chastened stock investors vowed that they'd never chase hot returns again after discovering they could vanish quicker than a box of Girl Scout Thin Mints.

Many bond investors, however, have never seen any need to flagellate themselves over their own investing habits. But their behavior can be just as irrational as the equity ambulance-chasers.

Too many conservative bondholders remain motivated by the same greed that compelled so many people to invest in tech startups with cutesy names and business plans held together with silly string.

Fixed-income enthusiasts are often attracted to bond funds that advertise suspiciously high returns, or they hunt for outsized bond yields that more levelheaded investors would understand are ephemeral. Investors, for instance, embrace high-yield corporate bonds, better known as junk, for fatter yields. More recently, investors have sunk cash into emerging market bonds because of their head-spinning performance.

Larry E. Swedroe and Joseph H. Hempen, the authors of the new book "The Only Guide to a Winning Bond Strategy You'll Ever Need," argue that embracing bond funds with larger-than-life returns can booby-trap portfolios because these fund managers typically invest in extremely risky bonds that don't provide commensurate rewards.

The potential for severe volatility isn't the only reason why Swedroe, a nationally known investment adviser, states unequivocally, "There is absolutely no reason to invest in junk bonds." The junk bond deserves to be ostracized, he argues, because it's a hybrid that behaves partly as a bond and partly as a stock.

The problem with this is that junk bonds slip into their equity role at the worst times. When stocks are getting creamed, junk bonds are often getting whacked, too. So instead of junk bonds providing some ballast when Wall Street is rocking, your portfolio will be reeling from a double whammy. For this reason, you should also keep away from another hybrid - convertible bonds.

You might be able to overlook the junk bond's irritating behavior if the asset class' historic returns equaled or surpassed stocks, but, Swedroe observes, they haven't.

Some readers may recall that this was one of the arguments that David F. Swensen, the chief investment officer at Yale University, also poses in his book, "Unconventional Success: A Fundamental Approach to Personal Investment." In his book, Swensen insists that "junk bond investors cannot win." Among junk's sundry crimes, he suggests, are that these speculative bonds are more expensive to buy and harder to dump.

Investors who invest in junk within taxable accounts face another drawback. The interest that junk bond coupons generate is taxed at ordinary income tax rates, which can reach as high as 35 percent. In contrast, if you hold stocks in a taxable account for more than one year, you pay long-term capital gains rates on profits, which max out at 15 percent.

If you're fond of junk because you believe it provides octane to your portfolio, Swedroe suggests that there's a better way to top off your tank. You can increase the percentage of stocks in your portfolio or boost your allocation of the riskier asset classes of small-cap, value and emerging-markets stocks, which have historically provided commensurate rewards.

Ironically, many aggressive investors mistakenly think that growth stocks are the best historic performers, but value stocks, over the decades, have easily captured the best-of-show ribbon. The combination of value and small-cap stocks have trounced its growth peers.

It's easy to avoid junk and other ticking-time bonds, if you restrict your bonds to their proper roles. Swedroe argues that bonds should be limited to playing three roles:

    - Safe haven. A short-term bond fund or money market is an excellent place to stash cash that you can't afford to lose.

    - Income producer. Retirees often turn to bonds to generate a stable stream of income.

    - Risk reducer. If you add bonds to an investment portfolio, you neutralize some of the volatility of stocks. Bonds let investors sleep better at night.

If you follow these guidelines, you'll restrict your bond choices to the two highest investment grades. U.S. Treasuries represent the safest choices because they carry no credit risks. When venturing into the corporate or municipal-bond universes, you'll want to stick with bonds that enjoy AAA and AA ratings.

Morningstar ( provides a handy resource for investors wondering about the quality of the bonds in a particular mutual fund. Just call up a fund's profile and click on "Portfolio." You can also find this information in a fund's annual report.

When embracing quality bonds, many investors ignore a fixed-income novelty that should be a fixture in most portfolios. Nine years ago, the federal government introduced a new breed of Treasuries that protects investors with a suit of armor against what may be their most feared nemesis: inflation. Treasury Inflation-Protected Securities (TIPS) represent the market's best pure inflation hedge. TIPS also enjoy lower volatility than such inflation-hedging investments as commodities and real estate investment trusts.

The cheapest way to buy TIPS is from the source through You can also obtain TIPS exposure through mutual funds. In keeping with his laudable fixation of keeping investment costs low, Swedroe recommends Vanguard Inflation-Protected Securities Fund. According to Morningstar, about two dozen TIPS funds now exist.

What has kept many fixed-income investors from nibbling at TIPS isn't ambivalence or even disinterest, but rather confusion. How much does a portfolio need? The book provides a handy guide that suggests when your portfolio should be more weighted toward regular Treasuries and when TIPS should get the nod. If you have no interest in monitoring Treasury yields, Swedroe suggests splitting your allocation equally between TIPS and regular Treasuries and keeping it that way.