Profit from debt.

DESPITE THE WOEFUL PERFORMANCE of '94's fixed-income market, bonds and other fixed-income securities should still be a part of any savvy investor's portfolio. But as last year's performance makes clear, a disciplined and pragmatic strategy is essential. Such a strategy should set up a steady income stream to increase wealth and enhance savings for future investments.

Last year was a real test of this approach. Long-term U.S. government bond returns fell to their lowest point in history, and analysts had to look back 30 more years to find worse returns for intermediate U.S. government bonds. Bonds of all categories--global, high quality, junk and municipals--recorded losses of between 2% and 4%.

Maintaining a diversified portfolio can, however, minimize losses. Certainly, there will always be periods of downturn since business runs in cycles, but you can be sure that things will lift again. The challenge is to set yourself up to take a first-strike advantage of opportunities when they arise.

This is true whether you're building a balanced portfolio or making a market play to create income that can be counted on over the long haul. Either way, it's important to understand the role bonds play in the fixed-income market.

To better explain the nuances of fixed-income investing, BE hosted its First Annual Black Enterprise Fixed-income Roundtable at our New York headquarters. A cross section of experienced specialists participated.

The group comprised Ladell Graham, co-founder, president and chief investment officer of Houston-based Smith, Graham & Co., the largest African-American-owned fixed-income asset manager with $1.5 billion invested; Marcos Jones, chief economist and director of fixed-income research for Raymond James Associates, the St. Petersburg, Fla., financial planning giant and fiull-service brokerage firm; Charles H. Self III, vice president of the Chicago money management firm, CSI Asset Management; Cynthia Plouche, managing director and chief investment officer with Abacus Financial Group, another Chicago firm; Vernon Reid, a money manager with 15 years of fixed-income experience, and principal and chief investment officer of Baltimore-based V.A. Reid & Associates; and William Michael Cunningham, a Washington, D.C.-based investment advisor, president of Creative Investment Research & Management and developer of a mortgage-backed security created by loans from minority financial institutions.

Their crystal ball gazing, which follows, gives specific advice for experienced long-term investors as well as newcomers, who have heard about the general predictability of fixed-income investments.

BE: Where should our readers put their fixed-income investment?

CYNTHIA PLOUCHE: Before we consider where, I think it's important to consider why. Individuals need to decide what their strategy should be, and what they want that strategy to do for them. Currently, there's a lot of cutting of social programs. Individuals having to offset those costs ask, "How am I going to put my nest egg away? How do I plan for my children going to college-or for other foreseeable debts?" You have to understand why you're investing.

VERNON REID: That's true. And I think that we're all in agreement that, as a people, African-Americans have been overly conservative with almost everything we do. I would argue that we have to diversify our investments and increase our rate of return. Too many of us keep practically all of our fixed-income investments in low-yielding bank accounts or savings bonds.

LADELL GRAHAM: Yes, if we look at individuals who keep their money primarily in bank accounts, CDs or other types of very conservative investments, the yield of nearly 8% that you can get today on five-year government securities looks pretty good. You could capture almost 90% of the return including 30-year bonds, now yielding about 8%, while locking yourself into only four- or five-year maturities. That means you'd have significantly less risk should interest rates shoot up well above 8% beyond that five-year period. You wouldn't have to wait 30 years for the bonds to mature, even if it happened before then.

MARCOS JONES: You're absolutely right, considering today's fairly flat yield curve. You're not going to get a significantly higher interest rate on a 30-year bond than you would on a five-year bond.

REID: Ladell made a good point about savings accounts, which are yielding about 4% to 5%, and CDs. Even if you ignore five-year securities, you'd be better off investing in a money market mutual fund that yields 5%. You'd pick up an additional 1% without any additional risk. Similarly, instead of buying a five-year savings bond at 6%, investors should consider buying a five-year Treasury note directly from the Federal Reserve, which currently is yielding 7 5/8%. These notes come out every month.

BE: You can buy Treasuries directly from the Federal Reserve without paying any brokerage fee, but how should an investor structure his or her portfolio?

CHARLES SELF: There are three major ways you can structure the maturity spectrum of a fixed-income portfolio. The first is the "ladder" method, where you hold different instruments with maturities staggered over different periods of time. Second, there's the "bullet" structure, where your portfolio is mostly in intermediate securities, with less cash and longer securities. Or you can take the "barbell" approach, in which you evenly mix cash and shorter maturities with much longer ones. Adopting one strategy or another depends largely on where you are in the economic cycle, where the yield curve is, and where you think the yield curve will go. I think that most individuals should have a laddered strategy; otherwise they are playing the unpredictable interest rate market.

REID: I think brokers, by and large, like to sell the ladder approach because it gives a good income stream. Most individuals either ladder it or take a bullet approach. But institutional investors with larger portfolios tend to buy long, buy short, and move their assets around.

GRAHAM: The barbell strategy is geared toward short-term phenomena that professional money managers can handle, but it's difficult for most individuals.

WILLIAM CUNNINGHAM: It's a short-term tactical strategy that you use for a year or two. It's not a strategy that you would put in place for 30 years.

REID: Most individuals would say, "Hey, I'm not going to be alive in 30 years; why would I want a 30-year bond? Maybe I should look at a 10- or five-year maturity."

GRAHAM: Sometimes we have short memories and we focus on what's recently happened. We say 1994 was the worst year ever in the history of the bond market. Until last year, the bond market never had a negative return. But because of last year, we tend to be overly cautious on the bond market.

BE: We keep talking about the five-year market. Are we disregarding the possibility that an 8% rate may look good 10 years from now?

PLOUCHE: Now you're talking about reinvestment risk. That's if you have a 6% bond that matures a year from now. The question is, there will rates will be when the bond matures? If rates are higher, say 7%, then fine, you've come out ahead. But if they drop, say to 5%, you have to reinvest the money that had been earning 6% at the lower rate. The most important thing is to diversify your assets, including their maturities; don't put all your eggs in one basket. For instance, you could use a bond fund to average your money. We think that the Fed is probably going to stay pretty active through the second quarter, but putting your money into the market a little at a time helps you spread your interest-rate risk. If rates do continue up, then you'll be in a position to take advantage of it. If they drop, you won't take as hard a hit.

BE: Are we in agreement that five years is as far as we should go?

SELF: In the long run, I think you can go out as long as 10 years, even though you can get the vast majority of the yield in five years...

PLOUCHE: Given today's environment?

SELF: Yes, because the likelihood of inflation during that period rising above the rate on a 10-year Treasury security is relatively low. We are continuing to go down a disinflationary path. Maybe we're at the bottom.

JONES: That's funny. We don't want people making bets on interest rates, but you do want them making bets on inflation? Why is this acceptable in the context of a laddered strategy? You don't want to make that bet in a bullet strategy.

SELF: That's exactly right. Even if you've missed the great interest rates of the early 80s, to get 7.5%-plus today and lock it in looks pretty good in historical terms.

JONES: You're just short of making a very strong point. In the early '80s, interest rates at the short term were 12% and higher; inflation was 9%. Now we have interest rates at the short term of about 5% to 6%, with inflation at 3%. Perhaps we have a better deal now.

SELF: Yes. The other point of my strategy is that if interest rates continue to rise, it will probably happen at the shorter end of this ladder. So, if I were going to invest a little money at a time, as Cynthia suggested, I probably would start at the back end; start with the 10-year or seven-year security, whatever your maximum maturity is. As time goes on, if the shorter securities go up in yield, you'll have higher returns on those securities.

BE: Let's look at some diversified sectors of the bond markets. Are there any opportunities in municipals?

REID: I don't invest in munis, but right now munis have the highest percentage ratio of return vis-a-vis taxable instruments since I've been in the market. So people look and say, Why not buy munis now?"

BE: Orange County [California] might be one reason. Risky investments made by its treasurer caused the county's bankruptcy.

REID: Orange County's problems certainly have put a damper on the muni market, but I live in Baltimore. I can do a moderate bit of research on the city and say, "Hey, instead of buying this five-year Treasury, maybe I can buy a five-year City of Baltimore muni, yielding almost 90% of a comparable Treasury issue, and pay no tax on the income."

CUNNINGHAM: I like the Peter Lynch approach--go with what I know. In the D.C. area, for example, we've got Baltimore, Montgomery County and Prince Georges County [in Maryland]. I can detect differences in the efficiencies of the various municipal governments because I drive through these areas. I don't see D.C. as a very efficient government right now, so I would stay away from their municipal securities.

JONES: But the Orange County example gives you the perfect counterbalance to that.

GRAHAM: If you looked at the return on their portfolios over the last 10 years, you could say, "Okay, this is a great, strong structure," but of course it was none of that.

JONES: I've been through John Wayne International Airport in Orange County and it's one of the most impressive facilities in this country. That doesn't tell you anything about what their treasurer is doing in the back office.

CUNNINGHAM: Let me defend myself Looking around is the first step. The second step is to find out who is running the money and to look at the offering information to see whether or not these guys are doing things like derivatives.

REID: Orange County put a pall on the whole muni market. If I'm looking at the underlying fundamentals of a certain municipality and the numbers haven't changed--it still looks good to me--the first thing that comes to my mind is, I'm sorry if I owned it before, but if I want to buy it now there is an opportunity because the price is low." Orange County, California, is not Montgomery County, Maryland, for example. If I was comfortable about Montgomery County before, I'm even more comfortable with it now because I'm getting another 25 or 50 basis points [hundreths of a percentage point]. I especially think 35-to 45-year-old professionals in a relatively high tax bracket should look strongly at the muni market.

BE: You brought up derivatives earlier. They caused a lot of rancor among investors last year. What are they, and are they ever appropriate for individual investors?

PLOUCHE: It's unfortunate the way the general public views things. They hear the word derivative and say, "Oh, my God!"

CUNNINGHAM: Derivatives are basically strings of options that are tied together to give you a projected investment outcome.

JONES: It doesn't need to be explained in such intimidating terms. Any time anyone signs a 30-year mortgage with no prepayment penalty, they are involved in a derivative because the actual maturity of that loan is unknown at the time it's signed. It can be prepaid after one month, 359 months, or it can go all the way to 360. The derivatives that have gotten all the headlines are typically much more complex then this hypothetical 30-year mortgage. But I guess we return to the obligation of any investor to educate themselves to technical terms. That's difficult.

PLOUCHE: Investors should ask: "Where is the oversight? Who is managing these assets for me?" Your individual broker aside, you've got to do your own homework to know who is handling the funds and what the allowances are.

GRAHAM: That's a tough thing to do. Even the so-called most sophisticated people, Kidder, Peabody, traded mortgage-backed securities probably as much as anyone on the Street...

BE: There is no Kidder, Peabody.

REID: That's what I'm saying. It's the same reason Drexel Burnham went belly-up. Drexel knew more than anybody about high-yield bonds in the '80s. Kidder, Peabody knew more about mortgage-backed securities than anybody in the '90s. These firms aren't around anymore, so if the experts don't have a good grasp on risk, how can you expect an individual to?

BE: Speaking of risk, what about international bonds?

CUNNINGHAM: The markets in Thailand, Malaysia, Indonesia and India have been growing rapidly. If you're going for the gusto," that's probably where you should look.

BE: How would our readership do that?

CUNNINGHAM: It would be tough for readers to buy a bond that is denominated in the Thai baht. You'd have to worry about two risks--interest rates and currency. Instead, you should get a mutual fund that invests in those sectors.

SELF: You can buy a fund in a specialized area of the Pacific Rim, South America or Europe, or you can buy an international or global fund.

GRAHAM: That, I think, is the more appropriate way to do it. I don't think that individuals should try to buy a particular international security.

BE: What about corporate securities? Are there any bond picks?

REID: Telecommunications. You've got TCI, which is probably one of the best communications companies in the world. They talk about merging with somebody every week, but that's a good company to look at. You've also got RJR Nabisco.

JONES: And General Motors...

SELF: Here's a point of clarification. In the stock market, everyone can go to the floor and buy or sell any stock that's listed on the New York or American Stock Exchange. But bond market trades are done on the telephone. Very few, trades ever see the light of day outside of the two people who made the trades.

BE: So why should our readers care?

SELF: Liquidity. It's a lot harder to trade your bonds than it is to trade in the stock market. Even if you don't take a straight loss when trying to sell earlier than maturity, the fees associated with such a sale will be much more than in a stock transaction.

BE: So you make your bond purchases for a specific goal rather than value at a particular time?

SELF: Right, you're buying an income stream.

CUNNINGHAM: Should black investors be concerned about a company's record? If Denny's came out with a 15% bond that matured in five years, it might be a great deal, but would you go for it?

BE: Investors should realize that if you're not going to invest in companies that do animal testing, that means that cuts you out of the entire cosmetics market, and likewise for pharmaceuticals.

GRAHAM: If you're not into violence, then you can't buy government securities because part of the government is defense.

BE: As we exit, are there any final tips or warnings?

CUNNINGHAM: We've talked about some important benchmarks today. One, look at the cash that you have available in various investments, and try to determine when you will need to have access to that cash.

REID: It's all about timing. If you need the money in 60 days to pay for a house, don't buy 30-year bonds. Try to match your assets versus liabilities.

CUNNINGHAM: Second, look for ways that you can invest in these things without cost to yourself, like going directly to the Federal Reserve to buy Treasury bills.

GRAHAM: Be aware of interest rate risk. If you might need the money prior to maturity, at least understand that you will lose principal if rates were higher than when you purchased it.

CUNNINGHAM: Finally, be aware of the cost of getting out of these investments. Some mutual funds charge exit fees. There might even be brokerage fees when you sell a Treasury bond or note.

Cynthia Plouche

Abacus Financial Group, Chicago 312-553-9300 A 1979 graduate of Harvard University, Plouche is one of three managing directors at Abacus. While municipal pension funds make up a large portion of the firm's client base, some of Ploucke's corporate clients include Ankeuser-Busch and the May department stores.

With about $280 million under management, governments, including agencies, make up roughly 40% of the firm's portfolio; mortgage-backs and asset-backs lumped together represent another 35% to 40%. The remainder of the portfolio, 20% to 25%, is made up of corporates, Plouche says.

Vernon Reid

V.A. Reid & Associates Inc. Baltimore 410-332-0893

Ten years after getting his MBA in finance from Indiana University, Reid set up his own investment advisory shop. Today, his firm manages slightly more than $200 million in assets.

"Most people in the business are looking for total-return type managers, except in down markets. Then they want a defensive manager," says Reid. About 80% of our portfolio is in government and corograte bonds. Our portfolio should yield a little less than the Shearson Lehman Government Corporate Index. That's probably a by-product of the yield curve more than anything else in the last quarter."

Ladell Graham

Smith, Graham Co., Houston 713 -739-1113

Investors in the stock market usually seek profits from increases in the share price. In contrast, bond investors usually seek a regular stream of income from interest payments, says Graham, president and chief investment officer of this fixed income, money management firm. Smith, Graham deals exclusively in fixed-income investments.

"Our philosophy is to maximize cash flow or income," says Graham. "Over the last decade, bonds generated a 200% return on investment, with 88% of that coming from interest payments to bond holders."

A FIXED-INCOME GLOSSARY

Bond. An interest-bearing government or corporate security that obliges the borrower to pay the holder interest, usually at specified intervals, and to pay the principal amount at maturity.

Liquidity. The ability of an individual or corporation to convert assets into cash or cash equivalents without significant loss.

Maturity. Date on which a bond or other debt instrument becomes due and payable.

Mutual fund. A fund operated by an investment company that raises money from shareholders and invests in stocks, bonds, options or commodities.

Principal. The initial sum of money invested in a fixed-income security.

Prospectus. A formal written offer to sell securities that sets forth the plan for a proposed business enterprise or the facts concerning an existing one. The information contained in a prospectus is necessary for investors to make intelligent and informed investment decisions.

Securities. Any stock or bond used to raise money.

Yield. The percentage rate of return on the principal invested by the holder of the security.

Yield Curve. A graph showing the yields on comparable securities of various maturities, ranging from a month to 30 years. Ordinarily, yields are lower for shorter maturities and higher for longer-term maturities.

Charles Self

CSI Asset Management, Wheaton, Ill. 708-682-9057

"We serve mainly pension and endowment markets," says Self, vice-president of this Prudential insurance company. Currently, the firm has $2 billion under management.

Currently about 40% of assets are in governments; 35% in mortgages, 12% in asset-backed securities, and only 7% in corporates.

"We have shortened the average length of our maturities a little by adding some two- and three-year securities in the recent months," says Self, "but we still have a very large proportion of 30-year securities."

William Cunningham

Creative Investment Research Management, Washington 202-722-5134

As a registered investment advisor, Cunningham has taken the process one step further. He not only performs finance-based research on companies but also offers his own brand of fixed-income products.

"We do research on minority and little-known banks, thrifts and brokerage firms. We also create financial instruments," says Cunningham. "We have recently designed a bond that is backed by loans from all minority financial institutions. What this allows us to do is shift assets away from, say, Asian banks to black banks."

Marcos Jones

Raymond James Associates, St. Petersburg, Fla., 813-573-3800

"One of the most dramatic changes in my line Of work, Fed watching, is the way the Fed changed its way of doing business last year," says Jones, chief economist for this regional investment banking firm. Historically, the Fed kept its policy secret, forcing the market to guess from its actions what its gools were. Last year, the Fed began stating publicly that it wanted rates to rise. It did that several times. "The change in the Fed's approach caused panic among fixed-income investors and money managers," Jones says. "As a result, short-term interest rates have doubled in less than a year."