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Wise Move For 2013? Buy Corporate Bonds

 January 04, 2013 09:39 AM


(By John Gerard Lewis) A decade of market savants came out in the Dec. 17 issue of Barron's with an unrepentantly bullish outlook for stocks in 2013. Their average predicted gain was 10%, with increases ranging from Adam Parker's uninspiring 1.4% to Stephen Auth's euphoric 17.4%. Achievement of the latter would put the S&P 500 index within a stone's throw of its all-time high.

Rarely do we see financial houses – which have stuff to sell to investors – trotting out pessimistic messages during Advent, so the forecasts of Parker (of Morgan Stanley), Auth (of Federated Investors) and the other eight aren't surprising. They variously cite improving circumstances surrounding the European sovereign debt situation, economic growth in emerging markets, and a likely retreat from the fiscal cliff.

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And the Barron's writer assure us, albeit in little more than a footnote, that, oh yes, these folks do remain well aware of the potential risks, which simply consist of their possibly being wrong about all of the aforementioned reasons that they otherwise adduce for being optimistic.

But I think they missed one risk. And it's a potential doozy.

In fact, it's at the top of the list for three even more heralded stalwarts who are just as unrepentant in their warnings about the financial markets. Indeed, Pimco's Bill Gross and Mohammed El-Erian coined the "New Normal" tag a couple of years ago to describe the economic and investment effects of global deleveraging that has been under way for a while.

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Slow economic growth, they contend, will continue for perhaps many years. The days of 10% average annual stock market returns are over, they say. Instead, investors should expect "bite-sized," single-digit returns – for a long, long time.

Also comes star bond fund manager Jeffrey Gundlach, who shares in the gloom. He avers that a "financial catastrophe" is en route, and investors should thus focus on capital preservation and inflationary times.

And economist A. Gary Shilling is no less dour, declaring that a market plunge is inevitable. The rise in equities over the past year, he says, has been due to a contrived factor: the Fed's easy-money response to an ailing economy. Investors have come to pin their hopes on the Fed's actions (the "Bernanke Put"), he says, instead of the reasons for those actions.

"I disagree with the ‘It's so bad, it's good' crowd," Shilling says. "Conditions are so bad, they are just plain bad." He says it will take up to seven years for Fed stimulus to have any effect on the economy, and thereby the markets, because it will take that long for global deleveraging to run its course.

"This grand disconnect is profoundly unhealthy – and a reconnection is inevitable," Shilling says. "When that happens markets will nose-dive."

Can the markets continue to rely on bad news being good news for seven years? Can such reliance last even into 2013? Who knows? But do you want to take that chance?

I don't, especially since I'm in the Baby Boomer generation that has increasingly less time to recover from investing accidents. If you're in the same circumstance, here's a recommended investment allocation as we head into 2013:

80%

Individual corporate bonds. Bond funds expose you to "maturity uncertainty," i.e., you simply don't know what the value of your principal will be at any given point in the future. Therefore, build a ladder of individual, investment-grade corporate bonds for the bulk of the portfolio. An inviolable rule: Hold them to maturity. This allows you to reinvest in higher yields as bonds mature over time—without having to worry about price fluctuations. Don't try to trade bonds when interest rates are low, as the principal value will become less than your purchase price when rates start rising.

If you really don't want to own individual bonds, you can invest in two low-cost bond funds: Vanguard Short-Term Investment-Grade Bond Fund (VFSTX), and Vanguard Intermediate-Term Investment Grade Bond Fund (VFICX). The fund managers can do the reinvesting for you. But stay away from long-term bond funds that will get killed when rates rise.

20%

With the rest of your fixed-income portfolio, reach for some yield. But even here, be careful, because a pure high-yield bond fund has two serious risks: 1) the potential for net asset declines when interest rates rise, and 2) defaults due to a bad economy. A 5% allocation to pure junk might be OK, but for the rest I would invest in one or more of the following:

The Covestor Stable High Yield model that I manage at Covestor.com. This portfolio is akin to an aggressive bond fund that's balanced to mitigate extreme losses or gains. It's a barbell approach that doesn't bet on a decline in bond prices, but has built-in brakes that are intended to kick in to at least slow any decline that might be caused by higher interest rates.

• High-quality, closed-end bond funds that use leverage to yield 4%-5%. And if they're municipal bond funds, they will be tax-free and therefore have real return of approximately 6%-7%. Many are offered by BlackRock, Eaton Vance, Nuveen and Pimco. Examples: BlackRock MuniHoldings Quality Fund II (symbol MUE); Nuveen Municipal Value (NUV); and DWS Municipal Income Trust (KTF).

• The DoubleLine Total Return Bond Fund (DLTNX) is another barbell fund. It currently yields 6% and has an average duration of just 1.6 years. That means that if interest rates were to rise 1%, the net asset value of the fund would theoretically fall just 1.6%. That's pretty low. And, of course, you'd still theoretically be getting 4.4% on your money.

Disclosure: The author is personally long VFSTX, VFICX and DLTNX.

Any investments discussed in this presentation are for illustrative purposes only and there is no assurance that any manager will make any investments with the same or similar characteristics as any investments presented. The investments are presented for discussion purposes only and are not a reliable indicator of the performance or investment profile of any composite or client account. Further, the reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions made by model managers in the future will be profitable.

Certain information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. The manager believes that such statements, information and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.

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