THE GREAT BOND CONUNDRUM / BARRON´S FEATURE ( HIGHLY RECOMMENDED READING ) )

Feature
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SATURDAY, APRIL 14, 2012
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The Great Bond Conundrum
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By STEVE GARMHAUSEN


Investors looking for yield face slim pickings these days—and serious risks. Some top advisors offer recommendations on how to get decent income.
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Dan Picasso for Barron's

Investors are facing paltry fixed-income yields these days, but turning to longer-term bonds to boost yield could make things much worse, many financial advisors agree.

"In our view, it's important now for investors to reduce the duration in their portfolios and look to protect principal," says Richard Saperstein, managing partner with New York-based advisory firm Treasury Partners. Duration measures sensitivity to interest-rate moves.



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Rather than lengthening maturities, many fixed-income investors are better off seeking yield by inching down the credit-quality scale or focusing on overlooked bond categories such as health-care issues and "private activity" munis, advisors say.




Holding a portfolio skewed to longer-term bonds poses an obvious risk in an ultra-low-rate environment: Sharply rising rates would crush the value of existing long-term bonds. And while the Fed has committed to keeping rates down through 2014, they ultimately have nowhere to go but up.




THAT'S WHY EVEN CONSERVATIVE income investors might want to take a fresh look at lower-rated bonds, Saperstein and others suggest. Such investments grow a bit safer in times of economic growth because issuers' cash flows tend to be healthier. "In a recovering economy, you can take on a little bit more credit risk," Saperstein says. "If you're naturally a double-A-rated buyer, you can look into the single-A category."



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Issuers that are saddled with lower ratings but are in turnaround mode can be especially compelling, according to Robert Heck, chairman and chief investment strategist with Heck Capital Advisors, in Rhinelander, Wis. The firm's recent buys include short-term debt of Ford Motor, whose junk-level BB-plus rating belies its strong recent performance. A recent Ford BB-plus issue maturing in June that Heck bought yields 1.15% to maturity versus about 2% for a Treasury 10-year issue. "With corporates, I am looking for turnarounds," says Heck. "And Ford is starting to tear the paint off the deck."


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High-yield bond investors should be mindful that their attractive yields come with a risk other than credit quality: Junk bonds' performance tends to rise and fall with that of the stock market because both rely on a strong economy for growth. When stocks fall, high-yield bonds won't provide much of a cushion, says Saperstein. "Watch out for stock-market risk in owning these bonds," he advises. "Take it in small bites."


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Picking the right industry can make all the difference in corporate bonds. Health-care paper, for instance, exemplify a rare category with a combination of high quality and attractive pricing, says Drew Zager, managing director with Morgan Stanley Private Wealth Management in Los Angeles.


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Although the industry is solid, there are enough negative headlines to crimp investor demand and keep prices attractive, he says: "Every year, there's a hospital or local nursing home that gets into trouble, and that keeps the category cheap."



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Buying callable bonds is another shrewd way to eke out additional yield, says Zager. Bonds that mature in 10 years but are callable in four currently yield about 2%, or twice the yield of comparable non-callable bonds, he explains. Duration risk is not a big concern, says Zager: Healthy callable bond issuers are likely to repurchase the bonds at the four-year mark.



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"PRIVATE ACTIVITY" MUNI BONDS, often tax-exempt, are also worth a look, says Zager. Such bonds are often used to finance things like airports, harbors, and toll roads. Because of certain tax concerns, mutual-fund managers often avoid private-activity bonds; the limited demand from these institutional buyers keeps prices low, which can translate into higher yields. Right now, four-year private-activity bonds yield in the neighborhood of 2%, or about double the yield of straight, tax-free munis, notes Zager.



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Investors with more of an appetite for credit risk might want to look at the financial industry, says Saperstein. Bonds of many of the large banks and financial companies are trading at attractive prices, in part because their credit ratings remain lower after the 2008 financial crisis, and in part because of concerns over their vulnerability to Europe's financial crisis.


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"These institutions clearly have repaired their balance sheets in the last four years," says Saperstein. "Their capital structures are stronger, and yet they still have risk."


.In recent years, many investors have been looking to dividend-paying stocks to stand in as income generators. They should proceed with caution, says Saperstein. The more you shift your portfolio away from bonds and toward stocks, the more the portfolio volatility increases, he says.


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"The problem," he says, "is that you're going from a fixed-income instrument that could mature at par to an equity investment that will go up and down with the stock market."




It's tricky business, income investing. But if you keep on your toes, you can still earn a decent return.

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