Bond Allocation Strategies and Types

Key Insight

A fundamental portfolio policy for a defensive investor involves dividing funds between high-grade bonds and high-grade common stocks. A general guiding rule suggests maintaining between 25% and 75% of funds in common stocks, with a corresponding inverse range for bonds. The standard division is often an equal 50-50 split. Traditionally, increasing stock allocation during protracted bear markets when 'bargain price levels' appear, and reducing it when the market seems 'dangerously high,' is considered sound. However, following these maxims is challenging due to human nature, as average investors tend to act in opposition to these principles, leading to market excesses.

The choice of bonds involves considering taxable versus tax-free issues and shorter versus longer maturities. The tax decision is primarily arithmetic; for instance, in January 1972, a 20-year 'grade Aa' corporate bond yielded 7.5% compared to 5.3% for prime tax-free 'municipals,' meaning a 30% income loss for municipals. Investors in a maximum tax bracket higher than 30% would benefit from municipals; this typically applied to single persons with taxable incomes over $10000 and married couples over $20000. Various bond types include U.S. savings bonds (Series E and H, offering absolute safety, money-back options, and yields such as 5.10% for Series H for nine years, or 5% compounded semi-annually for Series E if held to maturity, with federal tax deferral options). Other U.S. government bonds, including indirect obligations like 'Certificates Fully Guaranteed by the Secretary of Transportation' yielding 7.05% (1% more than direct obligations), state and municipal bonds (Federal tax-exempt, requiring high ratings like Aaa, Aa, or A), and corporate bonds (highest quality yielding 7.19% for 25-year maturity in early 1972) also exist.

While sacrificing quality can yield higher bond returns, ordinary investors are generally advised against such 'higher-yielding bond investments' due to increased individual risks like price declines and potential default. Savings deposits or bank certificates of deposit can be suitable substitutes for short-term bond investments, offering comparable interest rates to short-maturity first-grade bonds. Call provisions, which historically allowed issuers to redeem bonds prematurely at modest premiums, disadvantaged investors by limiting their participation in favorable interest rate movements; for example, American Gas and Electric 5% debentures sold at 101 in 1928, callable at 106, were redeemed in 1946 when they would have been worth 160 based on prevailing yields. Investors in long-term issues are now advised to sacrifice a small yield for noncallability over 20-25 years or purchase low-coupon bonds at a discount to gain protection against adverse call actions. Preferred stocks, while some may be good, are inherently weak investments lacking both the legal claim of bondholders and the profit potential of common shareholders, making them generally unsuitable for defensive investors except on a 'bargain basis.' Income bonds, though historically associated with financial weakness, possess advantages like interest deductibility for corporations and could be a stronger alternative to preferred stocks.