Creating the Perfect Portfolio: Fixed Income

by: Larry Meyers

I began this series of creaing the perfect porfolio with an overview of asset allocation, followed by large cap growth stocks, large cap value, mid cap growth, mid cap value, and small cap stocks. You can find them all here. Today I’ll be filling out the portfolio with fixed income, commodities, and international securities.

As it happens, I don’t have a lot of time to investigate individual bonds. There are a few corporations that have strong balance sheets that still have lingering high-yield bonds from tougher days, but for bonds, I stick entirely to ETFs and mutual funds.

High-yield bonds are themselves volatile and risky, so I only allocate 2% of the portfolio to them, and chose the SPDR Barclays Capital High Yield ETF (NYSEARCA:JNK). The ETF yields a sizable 8.25%, has a minimal expense ratio of 0.31%, and has an 3-year average annual return of just over 10%. The top holdings include bonds issued by CIT Group (NYSE:CIT), AIG, and HCA. Companies like CIT are what you'd expect to find in a junk bond fund. CIT, of course, went through some very dicey times during the financial crisis. The good news is that they've recovered.

I’m not fond of municipal bonds these days, given all the budgetary troubles of the states. I’ve allocated 2% to iShares S&P National Municipal Bond ETF (NYSEARCA:MUB). I’m allocating 2% to the Fidelity US Bond Index (FUBFX), which yields 2.94%. Besides US Treasuries, the fund also holds a large position in Fannie Mae (OTCQB:FNMA) bonds, presumably because the fund believes the US will back those bonds.

I also want 2% international bond exposure – despite the troubles in the international debt markets – so I’m choosing the SPDR Barclays International Treasury Bond ETF (NYSEARCA:BWX). The ETF has some volatility, offering the potential for modest capital gains. It’s up 5.89% YTD.

I’m not wild on domestic bonds as a whole these days, which is why I’m putting 6% into preferred stocks. These securities offer more safety than bonds do, have a modest potential for capital gains, but they depend on the overall health of the company that issues them. The best part for fixed income fans, however, is they yield anywhere from 5% to 9%. The SPDR Wells Fargo Preferred Stock ETF (NYSEARCA:PSK) is my choice here. It offers a great yield of 6.68% and is also up 5.60% YTD. Top holdings include preferred stock issued by Barclays PLC (NYSE:BCS), HSBC Holdings (HBC), Wells Fargo (NYSE:WFC), and AT&T (NYSE:T). Financials often have extensive preferred stock classes available. What I love about these holdings is that companies like Wells Fargo, which has well over a trillion dollars in assets, is a solid bank despite the financial crisis. AT&T is obviously not going out of business anytime soon. With preferred stock, we aren't concerned with growth (AT&T's is anemic), but with a solid balance sheet (AT&T's generates around $15 billion in free cash flow annually).

Rounding out fixed income, I’m putting 3% into utilities, 5% into real estate, and 5% into commodities and natural resources. iShares S&P Global Utilities ETF (NYSEARCA:JXI), yields 4% and gives me international exposure. I have knowledge of several individual REITs, but am playing it safe by choosing Vanguard REIT ETF (NYSEARCA:VNQ), which yields 3.28% and has returned 10% YTD. Its top holdings include Vornado Realty Trust (NYSE:VNO), to the tune of 15% of the ETF's holdings. Vornado managed to stay flat on cash flow during the crisis, and put out $250 million in FCF last year.

The macro economic situation demands exposure to precious metals and energy along with other commodities, so I’ve chosen iPath Dow Jones UBS Commodity Index Total Return ETN (NYSEARCA:DJP). On the natural resource side, the iShares S&P Goldman Sachs Natural Resources ETF (NYSEARCA:IGE) gives me broad exposure to energy (78%) and some basic materials (22%).

And yes, I’m well aware of the precious metal bull market. I plan to use some of my Special Situations allocation for that in my next article.

Finally, we have international and emerging markets to attend to. The Vanguard MSCI Emerging Markets ETF (NYSEARCA:EFA) attempts to match the emerging market index with a low expense ratio. I have a very large international allocation to fill, so I’m spreading my risk around by choosing Fidelity Diversified International Stock Fund (FDIVX), Pear Tree Polaris Foreign Value Fund (PGVFX) (formerly Quant), and First Eagle Overseas Fund (SGOIX). The first has a solid 7.53% annualized return over ten years, a full two points better than other funds in its category according to Morningstar. The second is a bit pricer than I like in mutual funds, with a 1.29% expense ratio, but you get the #1 fund ranking in its category. The First Eagle fund is also expensive at 1.92% expense ratio, but this 5-star Morningstar Fund is well-managed and outperforms its category.

Next time, I'll finish up the series with Special Situations -- a category in which I invest in speculative plays, trade around stocks I am intimately familiar with, and play with some income-generating options.

Disclosure: I am long VNO, DJP, JXI, IGE, PSK.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here