November 8, 2002

Markets May Change, But Need for Holding Bonds Doe

Oct. 28, 2002 -- Bonds have outpaced stocks in recent years, and though the pendulum could be getting ready to swing the other way again, they should still be part of any investor's portfolio, say several fixed-income fund professionals.

Lured by the heady stock gains in the 1990s, many investors let their portfolios "get out of whack" by ignoring bonds, notes John Rooney, a Scudder Funds fixed-income product manager.

In truth, the last three years show the dangers of avoiding bonds, since the Lehman Aggregate Bonds Index, a widely-followed fixed-income benchmark, rose an annualized 9.5% for the three years through September, while the Standard & Poor's 500-stock index dropped 12.9%.

Investors should also have some bond exposure because bonds provide preservation of principal, liquidity, current income, and lower volatility than other asset classes, points out Glenn Migliozzi, Northern Trust's managing director of fixed income.

Faced with the intricacies of the bond market, individual investors are often better off with bond mutual funds, Migliozzi recommends, since professional managers provide expertise in selecting bonds with strong call protection, diversification of issues, and attractive maturity structures.

While an investor's exposure to bonds may vary based on their time horizon and risk tolerance, a 60% stake in stocks and a 40% position in bonds is "a good rule of thumb," notes Rooney. Migliozzi suggests a more conservative mix of 43% in stocks, 41% in bonds, and 16% in cash.

Every fund investor, "even investors in their 30s," should have a core bond fund with corporate, mortgage-backed, and some Treasury bonds, recommends Rooney. Within core bond funds, diversification is essential, so investors don't limit their fixed-income holdings to one fixed-income sector, Migliozzi said.

An enhanced core bond fund with foreign and high-yield holdings may be advisable since these areas offer more diversification and the possibility of upside returns, says David Albrycht, manager of Phoenix-Goodwin: Multi-Sector Fixed Income/A (NAMFX) and Phoenix-Goodwin:Multi-Sector Short Tm Bond/A (NARAX).

Fixed-Income Sector Checkup

Each fixed-income sector has its pluses and minus, given the current market environment. U.S. Treasury bonds offer high credit quality, but their near-term outlook is uncertain, due to the likelihood of higher interest rates and rising federal budget deficits, said Migliozzi.

Agency mortgage-backed securities, such as Ginnie Maes, also offer high credit quality, but they are subject to prepayment risk, notes Phoneix's Albrycht.

Investment-grade corporate bonds can provide diversification, but they face event risk and default risk, said Albrycht. Because of these risks, Phoenix bond funds generally take smaller positions in investment grade corporate bonds, Albrycht said.

Municipal bonds should be evaluated based on an individual's tax status. While high-income investors an benefit considerable from muni bonds' tax exemptions, all investors should consider their overall after-tax returns, Migliozzi recommends.

High-yield bonds should be approached with care because they offer potentially higher payments than other fixed-income sectors, but also greater risk and volatility, notes Scudder's Rooney. The high-yield sector's weak performance in recent years highlights this drawback, Rooney said.

Emerging market bonds are also volatile, but they are less correlated with other fixed-income sectors, so they offer further diversification, Rooney notes. In recent years, individual country and issue considerations have become more important in emerging market bonds, increasing the importance of independent fundamentals, said Albrycht.

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