Diversify with bonds

August 1, 2006

Bonds deserve a niche in your investment portfolio; they provide a dependable flow of income and are less risky than stocks.

Bonds, like equities, come in all flavors and sizes, each with its own set of advantages and disadvantages. Lately, some investment professionals have been advising against investing in large amounts of bonds of any sort. That's because bonds normally lose value when interest rates are on the rise as they are now.

Nevertheless, bonds deserve a niche in your investment portfolio; they provide a dependable flow of income and are less risky than stocks. If you're young enough to be investing for the long-term, the temporary ups and downs in the price of your bonds need not be a concern. If you're nearing retirement, a goodly share of bonds with their steady income and relative stability can help you to sleep well at night.

If your financial status falls somewhere in the middle to upper income range, municipal bonds may be the right choice for you. That's because their interest income is exempt from federal income tax. Stick with municipals issued in your own state and their interest will also be exempt from state and local taxes. That move provides you entrée into the enviable triple tax-free status club.

For example, if you buy a municipal with a 4 percent yield, you'll wind up with an effective 5.33 percent, assuming you're in the 25 percent tax bracket. Of course, the attraction of municipals grows in sync with your tax bracket. If you're in the 35 percent bracket, that 4 percent effectively becomes 6.15 percent. Exemption from state and local taxes will raise that effective rate even higher.

TIPS, Series I

If keeping up with inflation is one of your major concerns, you need to know about Treasury Inflation Protected Securities (TIPS). They were introduced in 1997 under Treasury Secretary Robert E. Rubin. TIPS were conceived as a vehicle that would help to protect investors' purchasing power against the ravages of inflation. These bonds provide a base rate of return, plus an additional amount roughly equal to the current inflation rate. When inflation rises, the principal rises with it.

If you think you might be interested in TIPS, the important question to consider is whether inflation will rise enough to make up for the difference between the base return of TIPS and the yield on traditional Treasuries. Series I savings bonds, another type of Treasury, are also adjusted for inflation. They tend to have slightly lower rates than TIPS bonds but they grow tax-deferred, a very important consideration for some investors. Some analysts consider Series I savings bonds even more attractive for small investors than TIPS.

TIPS are issued three times a year, and you can buy them directly from the Treasury in denominations starting at $1,000. If you miss the sale scheduled for October, your next chance will be in January. You can also buy or sell TIPS at any time for a fee through your broker.

Treasury notes

Unlike TIPS, traditional Treasury issues are not guaranteed to keep up with inflation. A 10-year Treasury note bought for $10,000 is cashed in at maturity for $10,000; it pays interest twice a year. At the time of this writing, the yield on a 10-year Treasury note is 5.11 percent.

You'll find everything you need to know about all types of Treasury securities at the official Treasury Department Web site: http://www.publicdebt.treas.gov/

Mutual funds

There are also mutual funds dealing in Treasuries. I like mutual funds for individual investors, especially those with less than $10,000 to invest. Mutual funds put together portfolios of varying maturities, providing a degree of diversification that would be difficult, if not impossible, for the typical investor to attain.