Creating a Winning Bond Strategy

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

were wrong.

So what’s a bond investor to do? We’ve laid out four bond strategies that should help you make money in the asset class no matter which way the economic wind blows. We’ll also tell you how each type of strategy works when interest rates rise to help you minimize any damage.

Laddering For the last five years, G.G. Washington, a retired information technology director, has devoted the bulk of his fixed-income investing to laddering, a strategy that spreads money among different investment bonds that mature at different intervals and are reinvested at the best possible rates up until a designated time horizon. Washington divides his money into five equal pieces. Every two years, he invests in bonds with maturities ranging from two to 10 years. Among his holdings are bonds from General Electric, Loews, Lehman Brothers, and Ford, his former employer. Because bondholders are taxed on income from corporate bonds, Washington holds them in his 401(k), which is tax-deferred.

When a bond matures, Washington puts the money into a new 10-year bond. Every two years, a fifth of his portfolio comes due and he invests the proceeds into the longest dated bonds available.

“These are investment grade bonds, so I was pretty comfortable the corporations would not default,” says Washington, 58, who now does IT consulting for businesses and schools. “I hold them to maturity, so I’m not impacted by interest rate fluctuations.”

Should rates rise, though, Washington can reinvest at the higher rate when a bond matures. If they fall, which has happened over the last few years, the overall yield of the bond portfolio will fall too if reinvesting is done in lower interest bonds. However, this strategy allows for reinvestment in other fixed-instruments until corporate bonds are favorable. But, Washington still has a corporate bond in his portfolio issued by GTE
North Inc. that yields 8.25%. He purchased the bond in 2000 when rates were higher. The bond matures in 2005.

By laddering between one and 10 years, “effectively, what you end up with is the risk characteristics of a five-year bond,” says Steve Bohlin, manager of the Thornburg Limited Term Income Fund in Santa Fe, New Mexico, which uses a laddered approach. “Historically that’s been the best risk-reward relationship.”

Most advisers caution that you’ll need at least $10,000 to invest per bond. Otherwise the hefty commissions will greatly reduce the returns you’ll receive. Investors can achieve results similar to Washington’s laddering strategy by investing $10,000 or more through bond mutual funds.

Intermediate Bonds You would think that with interest rates being so low, you’d want to invest in longer dated bonds because they’d pay more. Hardly.

“Given the current interest rate environment, I think long-term bonds are not a good choice,” says Stephanie Hancock, financial planner and owner of Hancock Wealth Advisory in Los Angeles. “I tell my clients to stay in the one-, two- and three-year range.”

If the purpose of your bonds is to provide stability to your overall portfolio (as opposed to generating income to live on), invest in bonds that

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