Creating a Winning Bond Strategy

With the right approach, bonds can achieve outstanding returns in a volatile market.Here's how.

While shopping for mortgages to refinance her three-bedroom, loft-style home in a Los Angeles suburb and her vacation condo in Nevada, Karen Ellis couldn’t find anything better than a 5.8% interest rate on a 30-year fixed loan. That’s lower than the 7.25% rate she now carries, but hardly the giveaway she could have gotten in 2003 when mortgage rates fell below 5%. It’s important for Ellis, a 57-year-old pathologist, to trim as much cost as she can now because her expenses are rising in a number of areas. She’s seen gas prices spike in the last year, which had her shelling out $45, which is 50% more than the year prior, each time she filled the tank of her Lexus sedan.

A conversation with her financial adviser, Alfred McIntosh of McIntosh Capital Advisors L.L.C., hipped Ellis to the fact that interest rates were rising and she needed to make some adjustments. With roughly 40% of her investments in bonds, Ellis’ portfolio could suffer if rates go even higher. Since Ellis wants to retire from her job at a local hospital by 2009, it’s important that she prevent her principal from taking a major hit before then.

McIntosh helped Ellis come up with a solution. They moved a portion of Ellis’ bonds to shorter maturities–the date when the bond’s value should be paid–because they are less sensitive to interest rate swings. High-yield bonds, better known as junk bonds because of their low credit rating and low sensitivity to interest rates, were added, with a smattering of mutual funds that invest in bonds overseas. Finally, McIntosh recommended church bonds: debt issued by houses of worship that pay higher rates. Church bonds with a 61/2-year maturity yield between 5.2% and 5.9%. Bonds with a 91/2-year maturity yield between 6.2% and 6.9%.

While most investors have been focusing on the equity portion of their portfolios, conscientious investors like Ellis are tweaking their bond portfolios in light of today’s economic forecast. Bonds should be an important part of everyone’s investment strategy. “I’m afraid that interest rates are going higher,” says Ellis, “that’s why I have diversification in my bonds, so they provide more security in my portfolio.”

If interest rates rise, some bond holdings could take a hit that individual investors wouldn’t expect from such safe instruments. Bonds are supposed to be that portion of every investor’s portfolio that helps them sleep at night. You’re not likely to get rich, but you’re not likely to lose your shirt either. That’s not to say that there isn’t any risk.

For the last five years, the average bond portfolio has returned a cumalative 46.4%. The same investment in the Standard & Poor’s 500 Index, however, has produced a 8.6% loss. Even though bonds have performed better than equities in the last five years, long-term interest rates are now at 40-year lows. Bond prices drop when interest rates rise because investors aren’t willing to pay premium prices for older, lower-yielding bonds when new ones pay more.

Going forward, industry observers are predicting that

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