Smoothing Out the Ride

Updated on March 12, 2007.

WHETHER YOU are just starting your investing career or have already amassed a tidy nest egg, your portfolio needs some steady and reliable income. For younger people, that income will balance out the periodic dips in a stock-dominated asset mix; for those in retirement, it will provide money to live on. Don't believe us? Check out the applet below. It demonstrates the cushioning effect bonds had back in 2002, when the S&P500 fell 20% in the face of a continuing economic slump.

What we're talking about here is a long-term investment — a core commitment to the fixed-income arena that is unaffected by your view of the current state of the bond market or inflation. The strategy is to buy and hold your bonds until maturity, so the foundation should be safe, liquid government bonds — in particular, short- to intermediate-term Treasurys (those that mature in two to 10 years). Why not long-term bonds? Because as it turns out, long bonds barely outperform intermediates on a buy-and-hold basis. And in terms of balancing your overall portfolio, intermediates are less closely correlated to the ups and downs of the stock market.

Treasury notes are available in short maturities of three and six months, as well as longer durations of two-, five- and 10-year increments in $1,000 minimums. If for some reason you need to sell the Treasurys before they mature, Legacy Treasury Direct will sell them for you for a $45 charge, which is probably cheaper than going through a broker. Opening an account is free, although Treasury Direct accounts of $100,000 or more face an annual $25 maintenance fee.

It's hard, however, to gain any edge with these bonds over Treasurys. That's because they're generally available only through brokers and thus incur commission costs that cut into their yield. How much? The standard retail brokerage fee comes out to 0.5%, or, in the lingo of the bond world, 50 basis points. Even if you have $100,000 to invest and negotiate a lower commission, perhaps 20 basis points, the advantage over Treasurys will probably come to only around $50 a year.

The exception is if you have a very large portfolio and can sink perhaps $1 million into agency bonds; you might then be able to get the institutional commission rate of roughly 10 basis points. Or, at a more modest level, you might be able to hook up with a financial adviser who specializes in making bulk government-agency-bond purchases directly from banks, lumping clients' investments together in order to build million-dollar packages of agency debentures.

If you don't have enough now to build a muni ladder, the next best option is a municipal-bond mutual fund. Among the best are the Vanguard Intermediate Term Tax-Exempt and Vanguard High-Yield Tax-Exempt funds, which both have a minimum initial investment of $3,000. They maintain a low 0.17% expense ratio and are run with minimal maturity fluctuation and risk-taking.

Perhaps most important, though, is that the best bonds are usually callable by the issuer, meaning the corporation can, at its discretion, pay off its obligation at a stated price and stop paying interest, thus cutting off your expected income stream.