Bonds that Keep Up with Inflation (Forbes)

Forbes.com
Intelligent Investing Panel
The Case For Corporate Bonds
Alexandra Zendrian 02.10.10, 6:00 AM ET


Corporate bonds and equities have much in common--they have both had significant rallies since last March, and there are still opportunities in both markets for those willing to look for them.

"Default rates are down, and corporate earnings are improving," says Calvert Investments Chief Investment Officer Cathy Roy. She advises investors to buy corporate bonds from companies with strong fundamentals. Roy adds that investors should buy short-term bonds with durations of between two and five years as interest rates are slated to go up soon.

Knowing this Roy says floating-rate bonds are a good defensive play, as when interest rates go up these bonds get a boost. Calvert is underweighting mortgage-backed securities, as there doesn't seem to be a natural buyer in that market, and is also underweighting Treasuries.

Some financial advisors say corporate bonds are the best of a beleaguered bunch. To wit, corporates are in a much better place relative to Treasuries, says Shannon Zimmerman, an analyst with Motley Fool. This is because much of corporate America is deleveraging, while the government is taking on more debt.
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Still, since higher interest rates and inflation seem increasingly imminent, bonds could be adversely affected.

As a result, Zimmerman says to look to bond alternatives. One way is for investors to take about half of their fixed-income assets and put them into blue-chip dividend stocks like: Johnson & Johnson, PepsiCo, Coca-Cola Company and Kraft Foods. That way investors gain a more steady income stream through dividends but remain exposed to the upside of equities market.

This is also the time to consider Treasury Inflation-Protected Securities (TIPS), Zimmerman says. TIPS prosper in an inflationary environment because they rise with inflation.

In this recovery Advisors Asset Management Chief Executive Officer Scott Colyer anticipates lower-quality corporate bonds will recover better than higher-grade ones. Why? Because during recoveries riskier investments tend to outperform safer ones.

Not all agree. Brent Burns, president of wealth management firm Asset Dedication, says that investors should aim for higher-rated bonds because of their security. Since he anticipates some AAA companies will not maintain that status for long, he recommends AA bonds, as AA is the new AAA.

Burns recommends investors purchase individual bonds as they provide more control over their portfolio than an exchange-traded fund. This is because with an ETF you are stuck with the entire basket of bonds, whether you want them all or not. LPL Financial Chief Investment Officer Burt White also sees some opportunities in investment-grade corporate bonds. "Once corporations embark on a path of deleveraging and cleaning up balance sheets, corporate bonds benefit over long periods of time," he says. He adds that "corporate credit-quality trends tend to be long-lasting." White says that as companies' balance sheets get healthier, "the prospect for narrower yield spreads suggests additional room for improvement."

Though White sees opportunities in investment-grade corporate bonds, high-yield bonds remain his firm's favorite fixed-income investment. "Following the past two recessions in the early 1990s and 2000s, high-yield bonds posted impressive outperformance for the subsequent two years following a bottom in the economy and a period of underperformance," he says. White anticipates these bonds delivering high single-digit or low double-digit returns.

Other financial advisors prefer exchange-traded funds. "Most individual investors probably shouldn't buy individual bonds because of the lack of diversification," says Klingman & Associates Chief Executive Officer Gerry Klingman. He recommends the iShares IBOXX Dollar Investment Grade Bond Fund ETF and mutual funds such as the Dodge and Cox Income Fund (DODIX) and Vanguard Intermediate-Term Investment Grade Fund (VBIIX).

Investors mindful of the potential rise in interest rates can also try the Leader Short-Term Bond Fund (LCCMX). It's top five holdings are the Freeport-McMoran Copper & Gold Floating-Rate Note, Fifth Third Bancorp FRN, Citigroup FRN, Hertz 10.5% and General Electric Capital Corp.

John Lekas, president of Leader Capital, adds that investors should avoid emerging market funds because they can become so volatile so quickly. For an example, one need look no further than Dubai, where news of widespread defaults sparked a near panic.

Quick Tax Info: Codes in the Box in 1099 R (retirement withdrawal)

On my 1099-R, what do the codes mean?

1—Early distribution, no known exception (in most cases, under age 59 1⁄2 ).

2—Early distribution, exception applies (under age 59 1⁄2 ).

3—Disability.

4—Death.

5—Prohibited transaction.

6—Section 1035 exchange (a tax-free exchange of life insurance, annuity, or endowment contracts).

7—Normal distribution. Over 59 1/2 years old.

8—Excess contributions plus earnings/excess deferrals (and/or earnings) taxable in 2009.

9—Cost of current life insurance protection (premiums paid by a trustee or custodian for current insurance protection, taxable to you currently).

A—May be eligible for 10-year tax option.

D—Excess contributions plus earnings/excess deferrals taxable in 2009.

E—Excess annual additions under section 415 and certain excess amounts under section 403(b) plans. Report on Form 1040/1040A on the line for taxable pension or annuity income. If the IRA/SEP/SIMPLE box is checked, you have received a traditional IRA, SEP, or SIMPLE distribution.

F—Charitable gift annuity.

G—Direct rollover to a qualified plan, a tax-sheltered annuity, a governmental 457(b) plan, or an IRA. May also include a transfer from a conduit IRA to a qualified plan.

J—Early distribution from a Roth IRA, no known exception (in most cases, under age 59 1⁄2 ). Report on Forms 1040 and 8606 and see Form 5329.

L—Loans treated as distributions.

N—Recharacterized - IRA contribution made for 2009 and recharacterized in 2009. Report on 2004 Form 1040/1040A and Form 8606, if applicable.

P—Excess contributions plus earnings/excess deferrals taxable in 2009.

Q—Qualified distribution from a Roth IRA. You are age 59 1⁄2 or over and meet the 5-year holding period for a Roth IRA.

R—Recharacterized IRA contribution made for 2009 and recharacterized in 2009.

S—Early distribution from a SIMPLE IRA in first 2 years, no known exception (under age 59 1⁄2 ). May be subject to an additional 25% tax.

T—Roth IRA distribution, exception applies. (You may not meet the 5-year holding period.) You are either age 59 1⁄2 or over or an exception (code 3 or 4) applies.