How to Create a Modern Fixed-Income Portfolio

Fixed-income investing often takes a backseat in our thoughts to the fast-paced stock market, with its daily action and promises of superior returns. But if you're retired, or are approaching retirement, fixed-income instruments must move into the driver's seat. At this stage, preservation of capital with a guaranteed income stream becomes the most important goal.

Today, investors need to mix things up and get exposure to different asset classes to keep their portfolio incomes high, reduce risk and stay ahead of inflation. Even the great Benjamin Graham, the father of value investing, suggested a portfolio mix of stocks and bonds for later-stage investors.

If he were alive today, Graham would probably sing the same tune, especially since the advent of new and diverse products and strategies for income-seeking investors. In this article, we'll lay down the road map for creating a modern fixed-income portfolio. (For background, see "Preparing to Tap Into Retirement Income").

From the very beginning, we are taught that stock returns outpace returns from bonds. While historically this has been shown to be true, the discrepancy between the two returns is not as great as one might think. The Journal of American Finance conducted a study, "Long-Term Bonds Vs. Stocks" (2004). Using more than 60 staggered 35-year intervals from 1900 to 1996, the study showed that stock returns, after inflation was accounted for, measured an increase of about 5.5%. Bonds, on the other hand, showed real returns (after inflation) of roughly 3%.

One of the most important changes to fixed-income investing at the turn of th 21st century is that the long bond (a bond maturing in more than 10 years) has given up its previously substantial yield benefit.

For example, take a look at the yield curves for the major bond classes as they stood on Nov. 15, 2006:

Figure 1

Figure 2

Figure 3

There are several conclusions that can be reached from a review of these charts:

• The long (20- or 30-year) bond is not a very attractive investment; in the case of Treasuries, the 30-year bond currently yields no more than a six-month Treasury bill.
• High-grade corporate bonds provide an attractive yield pick-up to Treasuries (5.57% to 4.56% for 10-year maturities).
• In a taxable account, municipal bonds can offer attractive tax-equivalent yields to government and corporate bonds, if not better. This involves an extra calculation to confirm, but a good estimate is to take the coupon yield and divide it by 0.68 to estimate the effects of state and federal tax savings (for an investor in the  32% federal tax bracket).

With short-term yields so close to those of long-term yields, it simply doesn't make sense to commit to the long bond anymore. Locking up your money for another 20 years to gain a paltry extra 20 or 30 basis points just doesn't pay enough to make the investment worthwhile.

This presents an opportunity for fixed-income investors, because purchases can be made in the five- to 10-year maturity range, then reinvested at prevailing rates when those bonds come due. When these bonds mature is also a natural time to reassess the state of the economy and adjust your portfolio as needed.

The current relationship between short-term and long-term yields also illustrates the utility of a bond ladder. Laddering is investing in eight to 10 individual issues, with one coming due every year. This can prevent you from having to forecast interest rates into the future, as maturities will be spread out over the yield curve, with opportunities to readjust every year as your visibility gets clearer. (For details, see "Boost Bond Returns With Laddering.")

Adding some solid, high-dividend paying equities to form a balanced portfolio is becoming a valuable new model for late-stage investing, even for folks well into their retirement years. Plenty of large, established companies in the S&P 500 pay yields in excess of current inflation rates (which are running at about 2.4% per year), along with the added benefit of allowing an investor to participate in corporate profit growth.

A simple stock screener can be used to find companies that offer high-dividend payouts while also meeting certain value and stability requirements, such as those fit for a conservative investor seeking to minimize idiosyncratic (stock-specific) and market risks. Below is a list of companies with the following example screen criteria:

• Size: At least $10 billion in market capitalization
• High Dividends: All pay a yield of at least 2.8%
• Low Volatility: All stocks have a beta of less than 1, which means they have traded with less volatility than the overall market.
• Reasonable Valuations: All stocks have a P/E-to-growth ratio, or PEG ratio of 1.75 or less, which means that growth expectations are reasonably priced into the stock. This filter removes companies whose dividends are artificially high due to deteriorating earnings fundamentals.
• Sector Diversification: A basket of stocks from different sectors can minimize certain market risks by investing in all parts of the economy.

To be sure, investing in equities comes with considerable risks compared with fixed income vehicles, but these risks can be mitigated by diversifying within sectors and keeping overall equity exposure below 30 to 40% of the total portfolio value.

Any myths about high-dividend stocks being stodgy, non-performers are just that – myths. Consider that between 1972 and 2005, stocks in the S&P that paid dividends paid a return of over 10% per year annualized, compared with only 4.3% over the same period for stocks that did not pay dividends. Steady amounts of cash income, lower volatility and higher returns? They aren't sounding so stodgy anymore, are they?

Nothing like a nice piece of property offering rich rent income to enhance the golden years. Rather than turning landlord, though, you're better off investing in real estate investment trusts (REITs). These high-yielding securities provide liquidity, trade like stocks and have the added benefit of being in a distinct asset class from bonds and equities. REITs are a way to diversify our modern fixed-income portfolio against market risks in stocks and credit risks in bonds. For more, see "The REIT Way."

High-yield bonds, aka "junk bonds," are another potential avenue. True, these debt instruments offering above-market yields are very difficult to invest in individually with confidence, but by choosing a bond fund with consistent operating results, you can devote a portion of your portfolio to high-yield bond issues as a way to boost fixed-income returns. (See "Junk Bonds: Everything You Need to Know.")

Many high-yield funds will be closed-end, which means that the price may trade higher than the net asset value (NAV) of the fund. Look to find a fund with little to no premium over the NAV for an extra margin of safety when investing here.

Next, consider Treasury Inflation-Protected Securities (TIPS). They are a great way to protect against whatever inflation might throw your way in the future. They carry a modest coupon rate (usually between 1% and 2.5%), but the real benefit is that the price will be adjusted systematically to keep pace with inflation.

It is important to note that TIPS are best held in tax-advantaged accounts, as the inflation adjustments are made through additions to the principal amount. This means that they could create large capital gains when sold, so keep the TIPS in that IRA, and you'll be adding some solid inflation-fighting punch with the security that only U.S. Treasuries can provide.

Much like with high-yield issues, emerging market bonds are best invested in via a mutual fund or exchange-traded fund (ETF). Individual issues can be illiquid and hard to research effectively. However, yields have historically been higher than advanced-economy debt, providing a nice diversification that helps deter country-specific risks. As with high-yield funds, many emerging market funds are closed-end, so look for ones that are reasonably priced compared to their NAV.

This sample portfolio would provide valuable exposure to other markets and asset classes. The portfolio below (Figure 4) was created with safety in mind. It is also poised to participate in global growth through investments in equities and real estate assets.

Figure 4

The size of the portfolio will need to be measured carefully to determine the optimal level of cash flows, and maximizing tax savings will be crucial. If it turns out that an investor's retirement plan will call for a periodic "drawing down" of the principal amounts, as well as receiving the cash flows, it is best to visit a certified financial planner (CFP) to help with allocations. A CFP can also run Monte Carlo simulations to show you how a given portfolio would react to different economic environments, changes in interest rates and other potential factors.

As you may have noticed, we've often recommended fund options for many of the assets described above. Deciding whether to use one will come down to how much time and effort an investor wishes to devote to his or her portfolio – and how much in fees he or she can afford. A fund aiming to throw off 5% per year in income or dividends is giving up a big slice of an already small pie with an expense ratio of even 0.5%. So keep an eye out for funds with long track records, low turnover and, above all else, low fees when taking this route.

Fixed-income investing has changed dramatically in just a short period of time. While some aspects have become trickier, Wall Street has responded by providing more tools for the modern fixed-income investor to create custom portfolios. Being a successful fixed-income investor today just might mean going outside the classical style boxes and using these tools to create a modern fixed-income portfolio, one that is fit and flexible in an uncertain world.

There are risks associated with each type of investment listed here – aren't there always? Diversification among asset classes, however, has proved to be a very effective way to reduce overall portfolio risk. The biggest danger to an investor seeking principal protection with income is keeping pace with inflation, and a savvy way to reduce this risk is by diversifying among high quality, higher-yielding investments more than standard bonds.