Bonds: There's more to understand

It's tough enough to remember that when interest rates fall, the prices on bonds rises and visa versa. But now that the new tax law changes give a break to dividend yielding stocks owners, are bonds still a good investment? And, what about the high yielding bonds? They've been popular lately but are they worth the risk?

The bond arena is a large and sometimes complicated field. To help gain some insights on a few of the issues facing fixed-income investors today, I spoke with Kenneth J. Taubes, senior vice president and head of Pioneer's fixed-income team, about the current bond market.

Q: A few weeks ago I wrote about creating a laddered portfolio of bonds. Are you a fan of that strategy?

A: A laddered portfolio is a very systematic program of buying, essentially, several securities to simplify investing. But I don't think it works very well except in risk-free securities like government securities or Treasuries. If you're going to use corporate bonds, five or six securities doesn't cut it in terms of creating a diversified portfolio and managing it. So that doesn't lend itself to laddering. Again, in my opinion, you have to stick to the safest investments, like Treasuries.

Q: There's been a renewed interest in junk bonds lately. I'm puzzled because there have been times when the pros were advising people to stay away from junk bonds. Now they're suggesting we buy them. What's going on?

A: In the late 1990s, there were many transactions that were completed, particularly in certain sectors like telecom and energy, that were predicated on companies having significant growth in their businesses that didn't work out. So, there were a host of companies that got underwritten during the bull market that essentially shouldn't have been. A lot of those companies went bankrupt. Then, on top of that, the weak economy brought default rates on lower-rated bonds up as high as 10 percent.

But, when the economy began to stabilize, defaults began to dry up. So, with things like the aggressive easing of the Fed to ameliorate disinflation, the markets anticipating fewer bankruptcies going forward, and company fundamentals getting better, junk bonds have become more attractive.

Q: Are junk bonds a good investment?

A: They shouldn't be your only investment but they do make sense in the context of portfolio allocations. I do think that high yield will continue to do well, but I wouldn't advocate putting all of your eggs in one basket.

Keep in mind, that these markets are cyclical, too. They go up and down for good reasons.

Q: What about the impact of the tax changes on fixed-income securities?

A: It is clearly going to put fixed-income at a relatively less advantageous position that it was prior to the tax cut. Now, that doesn't mean it's like an on- and off-switch. People are going to need fixed-income regardless of the tax consequences. That's because, in a portfolio it, fixed-income provides steady income and lowers a portfolio's overall volatility more than equities do. That hasn't changed.

But, now that dividends are taxed at half the rate of taxable income, I think dividend paying stocks just got a little bit more attractive. Furthermore, because yields are so low at this time in the market, it makes for some very interesting things in relation to short-term bonds---the dividends on some company's stocks are higher than the yields on their bonds.

Q: So deciding whether to buy stocks or bonds becomes a tougher questions in some respects?

A: Sometimes stocks may make more sense, but if you're saving for your kid's college education which is coming up in two or three years, it doesn't make sense to move your money into stocks regardless of the tax consequences.

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Dian Vujovich is a nationally syndicated mutual fund columnist, author of a number of books including Straight Talk About Mutual Funds (McGraw-Hill), and publisher of this web site.