Why You Should Buy Bonds, Especially If Obama Wins

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David Evanson and Oliver Pursche

Forbes.com, Fall, 2012

I feel pretty confident that taxes on dividends, capital gains and most likely ordinary income will rise in 2013.

I base this not just on my belief that President Obama will likely win reelection, but also based on the simple math of what it will take to fix our budget shortfall and deficit, as well as our mounting debt.

I think President Obama is going to win the presidential election, and if I am correct, I believe another four years with him in office necessitates a closer look at the fixed-income portion of your portfolio.

Specifically, an Obama victory will stoke fear of higher taxes on dividends and ordinary income, and drive a rotation out of investment grade and high-yield corporate bonds and into municipal bonds. This is bad news for dividend champions such as McDonalds (MCD), Procter & Gamble (PG), 3M (MMM), Pfizer (PFE) and Exxon (XOM). Nonetheless, it looks to me like munies are mispriced and do not reflect this eventuality.

So, if I’m right, it will indeed take a village, or a city, or port authority or a state agency to make the most of your fixed-income investments.

That said, I also feel pretty confident suggesting that if you are looking at fixed-income, it would be prudent to consider individual bonds over bond funds and bond ETFs.

The risk in bond funds right now is two fold. First, should rates climb, bond values will fall, and therefore the risk of capital loss is palpable. I feel this risk is made worse when bonds are held in a mutual fund or ETF rather than individually. Specifically, because bond fund managers rotate in and out of bonds as rates climb, the risk of capital losses never, ever goes away.

With an individual bond, this isn’t a risk (or at the very least it’s limited). That is, the value of the bonds may fluctuate as rates rise and fall, but at the end of the day–assuming there is not default–that bond is going to pay out at par, generally 100%, and that means you get all your money back.

This leads me to the other advantage of bonds over bond funds: you can pick the maturity date and know with a high degree of certainty when you are going to get your money back. Funding tuition? Retirement? Home improvement? Buying individual bonds can keep you on track.

While bond funds will help you reduce risk in your portfolio relative to the risks in stocks while you wait out the arrival of a future date, you only get your money back when you decide to sell. And if tuition, or retirement arrives and your bond fund is underwater by a lot, or even a little, you may be reluctant to take the loss.

The second and more likely risk, really to bonds as an asset class, is that should all of the Fed’s quantitative easing come home to roost in the form of inflation, the purchasing power of bonds will erode.

Purchasing individual bonds can be a little tricky though. About the best you can say about the process is that it’s not quite as easy as buying stocks (though for some the ease of buying stocks has presented its own set of problems).

If you are convinced that buying individual bonds is right for you, I would recommend two resources. The first is a very good treatise offered by the American Association of Individual Investors (AAII) called How to Buy Individual Bonds: A Fixed-Income Toolkit. It’s free on their Web site by searching on the above title. The second resource is investinginbonds.com, a site run by SIMFA, the Securities Industry and Financial Markets Association.

Also, I think of municipal bonds as a portfolio hedge in the event (likely event) of an Obama reelection–they don’t pay much, but would expect price rally on account of fears of higher taxes.

The muni bonds are mispriced and I believe there will be a rotation out of the corporate and high-yield because for two reasons. One, wealthier investors will want to shield their fixed- income returns from higher taxes. This bodes well for municipal bonds. Two, corporate and high-yield bonds have appreciated significantly over the past 2 ½ years, much more than munies, institutional investors and money managers will likely rotate out of corporate bonds first.