Fixed Income Portfolios 

Bond Funds

In 2009 the bonds funds we own made our clients 13.85%, which was 7.95% better than the index (Barclays' Aggregate U.S. Bond Index). Our clients have received good returns on our bond funds for years. And they have never had to worry about losing their money.

At Secure Retirement, we use in-depth macroeconomic analysis to determine which areas of the bond markets are most attractive. This economic analysis is then combined with the investment discipline followed by Warren Buffett (and other students of Mr. Buffett's teacher Benjamin Graham), to select the bond funds we expect to deliver the highest returns - safely - each year.

These are not the easiest times to safely outperform in the bond markets. That being said, we expect our bond portfolios to continue to do quite well. This year they are a conservative combination of five mutual funds providing a competitive yield of approximately 6% in interest. In addition to the interest, these five funds are also designed to make extra money should the stock market go down. As we saw in the first quarter of 2010, they can also go up some in price when the stock market goes up.

By the end of the year, we expect to make 10% from our bond funds – 6% in interest and at least 4% in price gains. While not as high as the 13.85% our bond funds earned last year, we believe investments that safely make 10% or more this year will end up comparing quite favorably to most alternatives.

Looking Forward

A few clients have called me in recent weeks after reading or hearing so-called financial experts saying bonds are a bad investment. This belief is due to the fact that most bond prices do indeed go down when interest rates go up. With interest rates near all-time lows, it seems obvious that they will go up, so bonds must be a poor choice?

If we were required to keep all our bond funds for five years, I would agree with the skeptics, as I definitely expect interest rates to be substantially higher five years from now. However, this year (and most likely next year) we are still finding attractive prices in several areas of the broad bond market. But five years from now we will most likely have sold the two funds we own that will suffer as interest rates rise. These are exceptionally safe funds, but they will almost certainly go down modestly in price when interest rates go up. However, they are also likely to go up the most if the stock market goes down. This provides our clients with some additional risk control this year. But we do intend to sell these two funds before interest rates begin to rise.

Our other three funds may do well even after interest rates begin to rise. Two have substantial investments in Treasury Inflation-Protected Securities, a type of Government bond often referred to as “TIPS.” TIPS have typically been considered to be the safest investment in the world. They are backed by the U.S. Government, so you know you will get the money you loan back. (Since the Government can print money, they can always pay citizens back when their bonds mature.) However, if Government debts and deficits continue to rise unchecked, the money any bondholder receives back may be worth much less than it was originally. This is due to the fact that economies usually run into serious inflation when their debts and deficits become too large. Since inflation is the single greatest risk to retirement finances, this risk must be carefully monitored and controlled. TIPS are the most stable way to provide protection against this risk, as the principal value of these bonds rises in lockstep with the consumer price index. So in terms of safety, TIPS provide the best of all worlds. The Government will pay you back, and if the money is worth less due to inflation you will receive more to compensate you.

When interest rates and inflation do begin to rise substantially, we have already developed a complete fixed-income portfolio that will not only protect our clients' principal but also, we believe, deliver high returns. This will involve adding even more inflation-protected bonds and some foreign government and corporate bonds. When selecting international bonds, we look for bonds from countries that have three main characteristics: 1) The central bank follows prudent, anti-inflationary policies, 2) the government does not run large deficits, and 3) the economy and private sector are growing in a stable fashion. All other factors being equal, we also prefer bonds from countries that are rich in natural resources.

If one studies bond markets over time, you discover that there are always some areas of the bond market that are attractive. This is true even when the bond market as a whole is suffering. So while I am afraid most retired investors are destined to be disappointed with the bonds they own over the next five years, we are quite confident the fixed-income funds we own will continue to give our clients good income and the chance to get additional gains through price increases. This has been true through the years, it was true last year, and thus far it is proving true in 2010.