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Smoothing out the Ride


WHETHER YOU are just starting your investing career or have already amassed a tidy nest egg, your portfolio needs some steady and reliable income. For younger people, that income will balance out the periodic dips in a stock-dominated asset mix; for those in retirement, it will provide money to live on.

We're talking here about a long-term investment -- a core commitment to the fixed-income arena that is unaffected by your view of the current state of the bond market or inflation. The strategy is to buy and hold your bonds until maturity, so the foundation should be safe, liquid government bonds -- in particular, intermediate-term Treasurys (those that mature in two to 10 years).

Why not long-term bonds? Because as it turns out, long bonds actually underperform intermediates on a buy-and-hold basis. Using data spanning the past 30 years from investment-research firm Ibbotson Associates, SmartMoney calculated that over a 10-year holding period, a portfolio of Treasury notes with a constant average maturity of five years outperformed a portfolio of 20-year bonds (the standard benchmark back in the 1960s). The five-year notes returned 8.5% averaged annually, while the 20-year bonds returned 8%. In addition, intermediate notes are roughly half as volatile as long bonds. And in terms of balancing your overall portfolio, intermediates are less closely correlated to the ups and downs of the stock market.

Treasury Direct
If you are just starting out, you can simply buy five-year Treasurys, or -- if you have a lot of assets allocated for bonds -- you can put together a so-called ladder of Treasurys. Either way, your best bet for buying bonds is the government's commission-free Treasury Direct program, which allows you to bypass brokers and their fees. An application to open an account may be obtained online by linking to the New York Federal Reserve's Web site or by contacting your nearest Federal Reserve Bank. You can also call the U.S. Bureau of Public Debt at 202-874-4000.

Two- and three-year notes are available for a $5,000 minimum investment, while five- and 10-year notes have $1,000 minimums. You can set up an account online. If for some reason you need to sell the Treasurys in this account before they mature, you will have to have them transferred to a broker, who will charge at least $50 per transaction. In addition, Treasury Direct accounts of $100,000 or more face an annual $25 maintenance fee.

Agency Bonds
Also extremely safe and liquid, but offering a slightly higher yield, are government-agency bonds issued by the likes of the Tennessee Valley Authority, Farm Credit Financial Assistance Corp., the Federal National Mortgage Association and the Government National Mortgage Association. (These debentures should not be confused with the mortgage-backed bonds that are also issued by FNMA and GNMA; mortgage-backed securities are extremely sensitive to fluctuations in interest rates and should be avoided.)

It's hard, however, to gain any edge with these bonds over Treasurys. That's because they're generally available only through brokers and thus incur commission costs that cut into their yield. How much? The standard retail brokerage fee comes out to 0.5%, or, in the lingo of the bond world, 50 basis points. Even if you have $100,000 to invest and negotiate a lower commission, perhaps 20 basis points, the advantage over Treasurys will probably come to only around $50 a year.

The exception is if you have a very large portfolio and can sink perhaps $1 million into agency bonds; you might then be able to get the institutional-commission rate of just 10 basis points. Or, at a more modest level, you might be able to hook up with a financial adviser who specializes in making bulk government-agency-bond purchases directly from banks, lumping clients' investments together in order to build million-dollar packages of agency debentures.

Muni Bonds?
Investors with substantial income should also consider combining tax-free municipal bonds with their Treasurys. While the stated yields of munis are lower than those of Treasurys, the effective return for investors in high tax brackets is almost always better. As with treasurys, individual muni bonds can also be laddered to limit your interest-rate exposure. But because they tend to trade in fairly large lots (usually $25,000) and because, as a precaution against default risk, investors should spread their money among a variety of different locales, building a muni portfolio requires a commitment of $100,000 at a bare minimum.

If you don't have enough now to build a muni ladder, the next best option is to look to a series of municipal-bond mutual funds. The best are Vanguard's Municipal Limited-Term and Intermediate-Term funds (which both have a minimum initial investment of $3,000; call 800-662-7447 for information). They maintain a low 0.22% expense ratio and are run with minimal maturity fluctuation and risk-taking.

What About Corporates?
While investors have traditionally been steered to these vehicles because they offer higher interest income than government bonds, we are dubious about endorsing them. In part, it's a question of costs eating into those higher yields. First there are the taxes: Income from corporates is fully taxed at all levels. If your state and local rates (which are not applicable to government bonds) are a mere 6%, that would cut the effective return of an 8% yield to 7.5%. Next come the transaction costs: both brokerage commissions and the cut taken by the bond dealers (known as the spread). All told, they can easily eat up 1% or more of your investment.

Perhaps most important, though, is that the best bonds are usually callable by the issuer, meaning the corporation can, at its discretion, pay off its obligation at a stated price and stop paying interest. That becomes a heads-you-win, tails-I-lose proposition for investors. If interest rates decline and the value of the bonds goes up, the corporation may call them, disrupting your expected income stream and cutting off a potential capital gain. Meanwhile, if interest rates rise, you are stuck holding a less valuable security that is yielding below-market rates.

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