01/07/2013 03:49 pm ET Updated Mar 09, 2013

The Bond Peril

There are still many undervalued sectors in the stock market. From Japanese equities to Euro shares to good old-fashioned domestic dividend-payers, there are so many stocks trading at reasonable valuations that it's hard to choose.

The real peril is bonds. Not all types, but most.

People often think of bonds as being low risk. They are lower risk than stocks, but they are still subject to all sorts of different potential problems. There are three primary types of risk in fixed income: (1) Credit Risk -- the risk of default (2) Interest Rate Risk -- the risk that higher interest rates cause prices of existing bonds to fall, and (3) Inflation Risk -- the risk that, with or without higher rates, inflation will erode the relative value of existing bond interest payments and principal.

Credit risk is the least worrying in this environment. Corporate balance sheets have never been stronger. Municipalities, though strapped, are enjoying some increased revenues as the slow recovery grinds on. The Federal Government, while in wretched financial shape, is still unlikely to default.

The real risks come in the form of inflation and its antidote: higher rates. Credit risk is reasonably easy to guard against through diversification. Interest rate risk can be managed to an imperfect extent by keeping duration (the average length of time until all cash flows from a bond are received) as low as possible. Inflation risk is harder to guard against.

Conventional treasury bonds yield next to nothing and are vastly overpriced. As Leon Cooperman of Omega Advisors said recently, buying Treasury Bonds is "like walking in front of a steamroller to pick up a dime." Treasury Inflation Protected Securities (TIPS) are also overpriced, so where can you go for adequate yield and protection against inflation? This, not the debt ceiling or the macro concerns, is the biggest problem facing money managers today. The temptation could be to pile into high yield bonds, but the risk-reward is no longer there, with rates below the free cash flow yield on investment grade stocks. So where?

The three areas that still hold value are municipals (mostly by dint of their tax-free status), foreign sovereigns of solvent countries such as Canada, the UK and Australia, and BBB average-rated corporates (the low end of investment grade) where yields are still OK enough. I am actively shifting bond portfolios to continue to rotate into the few valuable remaining areas of the fixed income market.

One idea is to buy strong, consumer-staple, dividend-yielding stocks -- where you can get a 2.5 percent yield taxed at no more than 23.8 percent (at the new "fiscal cliff" deal + payroll tax eventual rate), and a payout that rises over time. It's not conventional to use stocks as bond substitutes, but the time is here for unconventional measures.

The author may own the above-mentioned securities, both in client accounts and in his personal accounts. This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation. All investment involves risk of loss. No one should invest in any financial security without reading the full prospectus and seeking professional, personalized advice, if required.