Take safety in bonds; here's how diversifying your portfolio with fixed-income investments can cushion the effects of market volatility. (Investing).

WILLIAM LOWRY AND TERI GONZALES-LOWRY MADE IT A POINT not to overreact during the bear market of 2000-2001. With the help of their financial planner, Jeffrey Hammond, the two Chicago-based nonprofit executives decided to stay the course they set for themselves years ago. While Teri's portfolio, which emphasizes stocks and stock funds, can withstand more risk because of a longer time period until her retirement, her husband, William, has a more conservative portfolio because he plans to retire soon. His basic allocation is 60% in bonds and 40% in stocks.

"A few years ago, I was tempted to put more money into stocks," says William, 66. "Everybody seemed to be making so much money in stocks that I thought I was losing an opportunity." Instead, he stuck with his bond-heavy portfolio, which he describes as "moderate growth and income." After watching the equity markets suffer two disastrous years in a row, he's glad he did.

"The people who made that money in stocks gave it all back," he says. "I might have had a small loss last year, but there were many people who were down 30% or 40%."

Hammond says last year he repositioned some of the Lowry's assets, putting more of their money into bond funds. However, since he believes interest rates may begin to climb this year, he's reluctant to add more bonds to William's portfolio.

The Lowrys illustrate the value of using bonds to diversify a portfolio, thus, minimizing market risk. William's investment in bonds enabled him to minimize his losses during a down market and protected his resources for his retirement. But you don't have to wait until retirement to take advantage of a bond's ability to buffer market volatility.

"Bonds should be about 10% to 15% of an aggressive portfolio," says Dale Bryant, portfolio manager at The Bryant Group in New York City. "In addition to U.S. Treasuries, investors should also think about corporate bonds and municipal bonds."

Younger people can also use bonds to their advantage (see, "Bond Investing for Young People," www.blackenterprise.com). Even though she has more time before retirement than her husband, Teri Lowry, 46, still has a significant exposure to bonds. Her portfolio is made up of 65% stocks and 35% bonds, and all the interest generated from the bonds is reinvested rather than spent.

Hammond has Teri invested in short-term and intermediate-term bond funds that typically deliver higher yields than money market funds. Holding the bond funds diversifies her portfolio and decreases her overall market risk, keeping her year-to-year results from varying wildly. And Hammond says Teri also has the choice to move into municipal bond funds, which can produce tax-free income.

"Past performance never guarantees future results," says Hammond, "but at least we have the positioning to take advantage of almost any situation that the market throws at us."

UNDERSTANDING THE VALUE OF BONDS

"Bonds are essentially a loan or purchase of debt from corporations, municipalities, or the government," explains William Landers, an investment advisor for the New York City-based WPL Financial Services. "The issuer promises to pay scheduled interest payments to the bondholder, and return the face amount of the bond after a specified period of time." It is the guarantee of a specific return at a specific time that gives bonds--also called fixed-income investments--their strength in an economy fraught with uncertainty. But bonds also have weaknesses. Bond yields (the annual income in dividends or interest that an investment returns) usually depend on the credit worthiness of the issuing body, so if you buy bonds from a corporation that goes out of business, your bonds will be worthless. Some bonds are given ratings to indicate their credit quality. Moody's Investor Service (www.moody.com) and the Standard & Poors Corp. (www.standardandpoors.com) rate bonds based on their capacity to make scheduled interest and principal payments. To make sure that you have the right mix of bonds in your portfolio, it's important to understand the pros and cons of all of them. (To understand bond ratings, see blackenterprise.com.)

U.S. Treasury securities, also known as T-bills and T-notes, are considered the most secure investment. Yields are relatively modest, ranging from 2.6% for a two-year T-bill to 4.5% for one that spans 10 years. The negligible risk involved with purchasing bonds from the U.S. government, coupled with the tax benefits (Treasury issues are exempt from state and local taxes), makes these securities attractive to both aggressive and conservative investors. "Most people know fixed-income securities to be Treasuries, and that's a good part of any portfolio," says Bryant.

Corporate bonds are securities issued by corporations to raise capital for specific projects such as building new facilities. Because they are generated in the private sector, corporate bonds involve more risk than Treasury issues and, therefore, tend to have higher yields.

Corporate bonds are divided into two main categories: blue chip and higher-yield. Blue chip corporates are issued by giant companies that are considered virtually infallible such as General Motors and IBM. "They're stable, and the yields can approach 6% to 7%," says Bryant. High-yield corporates, known colloquially as junk bonds, offer spectacular returns if the investor is willing to accept the risk that comes with his or her precarious credit rating. "All corporate bonds except blue chips are under question because some of the weaker issues might not be able to pay interest in a recession," Bryant notes.

Municipal bonds are issued by state and local governments and their authorized agencies to pay for various public projects such as highways and other infrastructure needs. Municipals generally have low yields, but they are exempt from federal, state, and--in several states--local taxes. "Municipal bonds make better sense if you're in the higher tax brackets," says Bryant. "They have low yields, but the triple-tax benefit looks good to wealthier investors."

Bryant says zero coupon bonds are a largely ignored but potentially powerful investment tool. "With zeros, the bond is bought at a discount, and the yield is actually the difference between what you bought the coupon for and how much its par (face) value will be at maturity," he says. The issuer will not make any interest payments over the life of the bond, but the interest will accumulate until it equals the face value. The depth of the discount price is dependent on the life span of the bond, with long-term securities offering the best yields.

Zero coupons are better suited for long-term bondholders who are not seeking regular interest payments from their securities. "For the more sophisticated, aggressive investors, zeros are a really good choice," says Bryant. Their comparatively cheap price is also an attractive feature. "If you have, for example, $10,000 to invest, you could buy ten regular bonds and reap the interest payments. But if you got into zeroes, you could spend half that amount on buying bonds with the same par value and also have some cash left to put into other types of bonds and stocks," Bryant explains.

The last category, preferred securities, are unusual in the fixed-income world because they are traded like stocks--available in denominations as low as $25 a share--and are listed on the major indexes. Preferred securities are widely known as fixed-rate capital securities and are called "preferred" because issuers are obligated to pay the interest before paying dividends on common stock. The yields on preferred securities, typically higher than other fixed-income investments, are paid every quarter.

"Preferreds are an easy way for a corporation, a bank, or a utility to raise capital. They are, however, a little tough to locate, but your broker should be able to get you a list of issuers offering them," says Bryant. Fixed-income securities are closely allied to the equities market, making them a questionable investment in these uncertain times. "If you like a particular company for stocks, then you may want to check to see if they're offering preferreds," says Bryant, adding that investors should be fully confident in the viability of an issuer before buying preferred bonds.

HOW TO BUY BONDS

Bonds should be a part of everyone's investment portfolio, whether you're just starting to invest or are trying to preserve wealth for retirement (See sidebar, "Bond Portfolios for Life"). Both Bryant and Landers suggest that inexperienced bond investors begin by purchasing bond mutual funds (see, "Which Way Is Up?" in this issue). Initial investments into most bond funds are the same as most mutual funds: $1,000 for the first purchase, with subsequent purchases available in $100 increments. The range of fixed-income securities available in a fund is also an attractive bonus.

One of Landers' clients, Rosalie Cochrane, 63, has avoided the unpredictable surges and declines in the equities market by maintaining a relatively high percentage of her investments in corporate bond funds. "My portfolio is around 47% to 50% bond funds, split between the Delaware Corporate Bond Fund (DGCAX) and the Delaware Extended Duration Bond Fund (DEEAX)," says Cochrane. A retired widow who lives, and works part-time, in Long Island, New York, Cochrane has relied on the interest payments from her bonds, currently yielding around 7.5%, as income for the past five years without having to touch her principal. "Her portfolio is structured to provide income that she can live on," says Landers, revealing that Cochrane bought her house two years ago using her returns. "[She] started her bond portfolio in 1996, and she's gotten a 17.86% return since inception."

Cochrane's main fund, The Delaware Corporate Bond Fund, concentrates at least 65% of its assets in high-quality securities rated BBB or above by Standard & Poor's. The fund returned 11.3% for 2001, outperforming its category by 4%, according to Morningstar. The fund managers may also mix in some high-yield bonds, which are restricted to below 20% of the fund's total assets. The remainder is invested into common and preferred stock, and cash and convertible bonds, which can be transformed into equity at an investor's discretion.

Once an investor decides to purchase individual bonds, there are a number of things to consider. "I would like for people to have a sprinkle of each type of bond," says Bryant. "My feeling is that the best values are in intermediate bonds, at least in the Treasury market."

After treasuries, Bryant and Landers advise investors to cast a wide net when augmenting bonds in, or adding bonds to, a portfolio. Just as you want to diversify your portfolio with stocks from a variety of sectors, Bryant says, "You want to hold a wide range of bonds in order to further minimize risk." He suggests municipal bonds, issued by state and local governments, as the next safest purchase. Although they are relatively low-yielding securities, investors shouldn't overlook their other benefits. "If you bought a five-year muni giving you a 3.02% yield, it would come out equivalent to a taxable five-year bond returning 4.37% if you're in the 31% tax bracket."

As for corporate bonds, Landers says that novice investors should approach with caution. A corporate's fate is tied to the credit rating of its issuing corporation, which is risky in today's economic environment when the recession and fears about deflation--a general decline in the price of goods and services--are keeping corporate earnings sluggish. "The higher the yield [on corporate bonds], the lower the quality," he warns, pointing out that the assumption of excessive risk runs counter to the purpose of fixed-income investing. "Everybody should have some bonds as part of their overall portfolio, but unless you are fearless, you will always want to minimize the potential downfall."

Remember, bonds are simply another investment vehicle that can produce returns. You can enjoy the safety they provide by purchasing bonds that lock-in a specific rate of return during down markets, or you can ride the strength of the market in good times. As Landers likes to say, "There's a bond out there for everybody."

BOND PORTFOLIOS FOR LIFE

Dale Bryant, portfolio manager at The Bryant Group in New York City, says people of all ages should incorporate bonds into their investment portfolio. He has fashioned three sample portfolios, taking the following factors into consideration.

In the current economic environment, Bryant says, stock price ranges will remain low until corporate earnings improve and layoffs slow down. He believes the real story for investors lays in preferred allocations, which have higher yields that can compensate for lower money market rates (some below 2%). An average blue chip preferred is yielding 6%-7%. With some work you can find 8%-9% yields.

Bryant believes the Federal Reserve may lower interest rates one more time, bringing them close to zero. From there, rates will only go up which will limit bond price appreciation and make yields less attractive. "I would look to a good corporate bond fund as the economy rebounds," says Bryant. "The bond selection [in a portfolio] should be split 50/50, treasury bonds and corporate bonds."

Age: 35 and younger

Designed for: investors new to the market, younger with
longer time horizon. Primary objective is wealth accumulation.

                           BRYANT'S
ASSET CLASS    RANGE    RECOMMENDATION

Stocks        60%-80%        65%
Bonds          10-20         10
REITS           5-15         10
Preferreds      0-10         10
Cash            0-10          5

Here we use nonstock investments as a cushion. Bonds
shouldn't be viewed as a disadvantage to a portfolio because
bonds beat stocks for the second year in a row. REITS also
had a good two-year run. New money should go into stocks.

Age: 36 to 50

Designed for: investors who have been in the market for
some time, middle-aged. Primary objective is growth
with some caution.

                           BRYANT'S
ASSET CLASS    RANGE    RECOMMENDATION

Stocks        50%-70%        55%
Bonds          10-25         15
REITS          10-20         10
Preferreds      5-15         15
Cash           10-20          5

Here we still look for growth, but increased exposure to bonds
and preferreds allows seasoned investors to sleep at night
and avoid portfolio disasters.

Age: 50 and Above

Designed for: older investors preparing for retirement--assumes
investor has saved at least 70% of retirement objective.

                           BRYANT'S
ASSET CLASS    RANGE    RECOMMENDATION

Stocks        30%-60%        40%
Bonds          20-30         25
REITS          10-25         15
Preferreds     10-25         20
Cash           10-30          5

Here stocks play a less important role than securities
with a yield; allows investors to view their portfolio
as a source of living expenses.

Source: Dale Bryant, portfolio manager for The Bryant Group,
www.bryantgroup.com