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In this volatile economic climate, the decision to invest in stocks vs. bonds feels like a good cop/bad cop routine. Which one do you trust? At the moment, bonds and bond funds do represent a good alternative to stocks, offering income, stability and less volatility, although they do have their own market fluctuations. Bonds and bond funds, known as fixed income investments, also have their own risk ratings and rates of return.

Here is a quick look at the major fixed income categories:

Multisector bond fund: This is a mutual fund that invests in a variety of bonds in one allocation, allowing the fund manager to choose between the best performing Treasuries, corporate bonds, mortgage-backed securities, high yield bonds, and global instruments. How well the multisector performs is dependent on the fund manager’s expertise at deciding the ratio of each sector included. The big plus is diversification and the convenience of not loading up your portfolio with several different mutual funds, each specializing in separate bonds. Although last year’s overall bond performance was weak, the multisectors held their own because they could shift to government issues, which offset the under performing assets.

Treasury Inflation Protected Security Funds (TIPS): TIPS are US Treasury notes and bonds that have a fixed rate of return and are date-specific in terms of maturity, which is why they are considered safe havens. The potential upsid is that the funds rate is tied to the consumer price index, the so-called inflation rate. This means if interest rates and living costs rise during the bonds life, this can enhance the value of the fund (as interest rates rise). These have the backing of the government, investors can at least be assured of getting their face value at maturity.

Individual Bonds/Corporate Bonds:  It’s a given that government backed bonds are safe, but at a cost. Their rate of return is historically low. Investment-grade corporate bonds, conversely, are yielding averages that are higher. Historically thought of as a risky sector because of the fund’s dependence on both interest rates and industry performance, the reality is their default rate is low (the last time they tanked was during the Depression). Best route is a mutual bond fund as the shares never mature (yields now average 5.5% and higher). Keep in mind, there may be capital gains if interest rates fall to normal levels or the fund buys bonds at a discount.

Municipal Bonds:  These are bonds issued by state and local governments to fund schools, hospitals and other municipal projects. Their yields are exempt from federal and state income taxes and can be purchased as individual bonds, unit trusts or muni bond funds. Yields on these investments pay either semi-annually, quarterly or monthly depending on the venue. Rates are based on both length of time before the bonds mature, their current price and the credit quality of the municipality or the revenue of the project they are funding. This sector has seen a surge in interest since the start of 2009 as many of these funds have been selling at a discount after investors were forced to sell below maturity value to raise capital and increase liquidity during this down turn. A definite buyer’s market.

Convertible Bonds: These test the market in equities but with bond reliability. The holder of a convertible bond or bond fund can opt to exchange the bond for a predetermined number of common shares of company stock. Convertibles are potentially the best of both worlds- the protection of fixed income securities with the upside of equities. 

Integrating many of these bond strategies in your portfolio can increase income and reduce the overall risk rating of your asset allocation. Consider your tax bracket and whether or not you need taxable or tax-free income and whether or not you are comfortable with locking in at current rates or would rather be afforded the flexibility of being in an open ended mutual fund. Keep in mind that the biggest reason that bonds are flourishing now is because of historically low interest rates. As soon as the economy heats up, your overall bond strategy will need to be reviewed.

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Tags: bond fund, bond market, convertible bonds, corporate bonds, fixed income investment, individual bonds, interest rates, lee rosenberg, multisector bond fund, municipal bonds, treasury inflation security funds

About the Author: Lee Rosenberg is the Co-founder of ARS Financial Services, Inc. As a Certified Financial Planner with more than 34 years of solid financial expertise. Lee is a registered representative of Cadaret, Grant & Co., Inc. He was also named one of the top 25 Independent Financial Advisers in the US by Rep magazine.

This entry was posted on Monday, April 27th, 2009 at 10:30 am and is filed under Personal Finance. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.