Answer To A Reader's Questions

Someone named davpac left a comment on the blogspot version of this blog asking about different fixed income ideas. I thought it was a good question and since davpac didn't leave an email address I will publicly post my answer. First let me say I try to acknowledge every comment or email I get with either an emailed response or by posting a comment. While I am thrilled that people read this site, there is nothing that says they have to, so I am thankful for readers and people that leave comments.

I am not a big fan of buying individual bonds for people. Bond dealers are not very friendly to individual investors. The marking up and marking down of bonds is so rife with unfair protocol that I am shocked that the Spitzer crew didn't go after that part of the industry ages ago. If you own a bond that you have to sell, you should have zero expectations of getting a fair price. The typical investor has very small positions in a bond. Those small positions can be very difficult for the broker to sell to someone else. That means the broker may have to hold the bond for a while. That means you have to compensate the broker for taking the bond off your hands.

Davpac asks about several fixed income alternatives. The first one in his email is CEFs that invest in municipal bonds. These types of funds usually use leverage. When rates rise, these types of funds get slapped hard. You can take a look at the chart of just about of these from July 2003 to see the effect. If anyone finds one without leverage I'd be curious to know about it.

Next davpac asks about REITs. There are several types of REITs. The only kind that really scare me are mortgage REITs. The mortgage business has more potential for shenanigans than other types of REITs. People swear by Annaly Mortgage (NLY) and it may be great and clean but when Novastar (NFI) got hit a while back NLY, clean business and all got whacked too. One word of caution for other types of REITs is they can go down in value. Believe it or not some of the closed end REIT funds can be more volatile than individual REITs and REIT ETFs yield less than most individual names. I think individual REITs are the way to go and I use a couple of them in my practice.

I am quite fond of preferred stocks. There is no shortage of AA companies with preferreds yielding in the sixes. One word of caution is watch the maturity/call dates. I expect the next big move in rates to be up. If that turns out to be correct long dated preferred stocks with no call feature will get hit hard. I would mix maturities favoring shorter dated issues. I would also avoid CEFs that own preferreds because in a rising rate environment a fund's price could go down a lot more than the NAV.

The last item on davpac's list was emerging market CEFs. I'll broaden that to include foreign bond funds. There are a few CEFs that buy foreign bonds and I use a couple of them in my practice. The yield is good, but not extraordinary, and if rates in the US do rise these types of funds should hold their value. I also wrote a piece that explored the idea of a CEF that just owned European bonds. It looks like such a thing doesn't exist yet. I have a lot of readers from sell side firms. If anyone works in an area of influence over such things, here is a vote for a European bond CEF for US investors.

One last type of fixed income CEF that davpac does not ask about is convertible bonds. There are a couple of these out there. The thing with converts is as the stock goes up to the conversion price the bond starts to trade higher too on the likelihood of conversion. As the stock trades lower the bond starts to trade more like a bond. I favor a fund because any one deal can blow up and also the trading friction I referenced in the muni paragraph.

The covered call fund is down a little bit from where I bought it and where I own it for most clients, I bought some this week for a couple of new clients and they are even on it, but have already collected a dividend. We'll see how it goes but I am in favor of innovative investment products and I expect that the covered call funds will be a good thing.

Something else to keep in mind is a hedge. There are several open end funds that short the bond market. I use one of these for some accounts. They will go up in price as bond yields rise. By themselves these types of funds are very volatile but as part of a fixed income portfolio they reduce overall volatility.

My strategy for fixed income is similar to equities. I want own different parts of the fixed income market for diversification. All these products have similar yields but are likely to react differently to various types of events which will protect my clients if I really goof up.

Here a a couple of resources that come to mind to research these things more; ETF Connect and Quantum Online.

Hopefully davpac wasn't just asking me what time it was and I told him how to build a watch, if you catch my drift.