Income Builder - Three Fixed Income Investing Strategies |
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Back to Index Option 1: The Mutual Fund Approach Some financial advisors, such as Suze Orman, are not fans of bond mutual funds. They believe that fund expenses generally are too high. They also believe that you lose some of the inherent advantages of owning your own bond portfolio, like the buy-and-hold-to-maturity strategy, because bond funds constantly roll over their investments and so do not have a set maturity. This gives investors at least some exposure to market risk upon redemption. More recently, Business Week reported that many bond funds are trafficking in credit default swaps. As a result, investors in these bond funds may be getting something for which they did not bargain: they may exposed to potential losses in the future on these arcane financial instruments. All other things being equal, I too believe that a self-managed bond portfolio is preferable to a portfolio of bond mutual funds. However, many investors do not have the knowledge and are unwilling to devote the time to learn how to create and manage their own bond portfolios. For those investors, I believe that bond mutual funds are an excellent alternative. Although annual fund expenses generally run from 0.50% to 1.00%, that should be money well spent. As noted, it takes a lot of work to manage these portfolios; so it is in the best interest of investors that fund managers are adequately compensated. Under this approach, investors primarily play the role of a strategist. High quality short-term bond investments should still be at the core of this portfolio, but investors can take advantage of opportunities and try to reduce risks by monitoring financial market trends. For example, they should monitor yield spreads across various sectors within the bond market to identify areas of opportunity and risk. They should then reweight portfolio allocations by shifting money from one or more bond funds to others in response to developments in the economy and financial markets. Option 2: The Individual Investor Approach This, I believe, is a better approach, but it requires a more significant commitment of time and effort by the individual, especially at the outset, to learn about bond investing, including how to monitor the bond market, spot good relative values, assess the likelihood of default and purchase securities at the best prices. Once the individual is up to speed, it should require no more work than a stock portfolio. Experienced investors with good experience in researching and investing in common stocks should find the task much less daunting. In fact, a company whose stock is viewed as high quality (or low risk) should also be an issuer of high quality bonds. In this way, experienced stock investors may be able to use their existing knowledge to develop an initial target list of bond investment candidates. In order to pursue this strategy effectively, some investment advisors believe that you must be able to commit at least $50,000 to a bond portfolio. From my perspective, this may work if you are focusing mostly on T-bills, TIPS or bank CDs. However, if you are seeking to buy individual corporate or municipal bonds, I believe that investors ought to be willing to devote at least $100,000 to a portfolio, consisting of 10 separate investments of $10,000 each. This is necessary to achieve an acceptable level of diversification. Most brokers view $10,000 - equal to a purchase of 10 bonds, each with $1,000 par value - to be the smallest desirable order size. Some advisors, such as the Richelsons, believe that each of your bond positions should be $25,000 in size in order to get the best price offerings. If you are unable to commit $100,000 to this strategy, then you are better off pursuing either Option 1: The Mutual Fund Approach or Option 3: The Investment Club Approach, discussed below. Option 3: The Investment Club Approach From my perspective, this is the most desirable approach, but it also requires a lot of work, especially in the beginning. Here, a group of investors gets together and pools their money to purchase a portfolio of bonds. This is not an uncommon approach in stock investing. Indeed, the National Association of Investment Clubs (www.better-investing.org) serves thousands of clubs across the country. An investment club requires the establishment of a legal entity, usually a partnership, that is governed by a formal agreement and a set of by-laws or operating procedures. In my opinion, a bond investment club should have minimum capital of $200,000, which would allow it to buy eight $25,000 positions or twenty $10,000 positions. Better still to have $500,000 to put to work, as this would give the club the ability to pursue larger bond positions and/or a wider range of fixed income investment opportunities. According to those experienced in the operation of investment clubs, members should ideally have the same investment philosophy to ensure that the club runs smoothly and avoids conflicts. With stock investing, it is much more likely for there to be a wide range of investing styles and strategies, ranging from short-term day-trading to long-term buy-and-hold investing or from growth-oriented to dividend-oriented investing. With the bond investment strategy that I have articulated here, however, I believe that it would be much easier for club members to “be on the same page.” One primary advantage of the investment club approach is that it makes it possible to spread the workload more evenly, so that all club members can benefit from the group’s collective efforts. Some investment club veterans say that this is nice in theory, but difficult to achieve in practice because most of the work ends up falling on only a few shoulders. That would be a shame, especially in this situation. Since bond investing is a relatively new arena for the individual investor - one that is likely to grow rapidly in the coming years - an investment club offers everyone the opportunity to learn about all aspects of it much faster than if each operates on his or her own. Back to Index _________________________________________________________________________________ Originally published February 28, 2008 Stephen P. Percoco © 2008 Lark Research, Inc. All Rights Reserved. Information is carefully compiled but not guaranteed to be free from error. Specific reference to any specific security should never be construed as a solicitation to either buy or sell. Reproduction without permission from the publisher is prohibited. |
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