Don't Shortchange Long Term Bonds

Less than two-tenths of a point separates the yield on two-year Treasury notes

from the 7.9% of 30-year bonds. So why stick your neck out and go long when you can get almost the same return on a short-term note with a lot less risk? That's why many investors are choosing short durations. But the case for locking some of your money in bonds of five years or more is growing stronger.

This hinges largely on the belief that the inflation threat is over. The Federal Reserve is likely to raise rates at least once more, but many economists believe the aggressive tightening of the past year will start slowing the economy in early 1995. That should keep a lid on inflation and interest rates. And for long bonds, that's good news.

Bonds yielding nearly 8% offer returns almost 5 points above the current 3% inflation rate. Even if inflation hits a heady 4.5%, you still have at least a three-point margin of safety. "The current spread above inflation is at the high end of the range for real return," says Dennis Bushe, a fixed-income strategist at Prudential Securities. There's even some room for market rates to rise without investors taking a bath--if they confine investments to midrange maturities. Rates for 10-year bonds would have to hit 9.14% in a year for you to merely break even on the price when selling bonds bought at current rates, says Robert Rodriguez, president of FPA New Income Fund.

The shape of the yield curve is indicating that rates aren't likely to rise that high, many bond analysts say. When the curve is steep--as it was in October, 1993, with 30-year T-bonds paying 6%, vs. 3% for short-term bills--that's an indication rates may rise. When the curve is flat, as it is now, or inverted--meaning that long-term bonds are paying the same or less than short-termers--that's often a signal rates will fall. Another way to think of it is to draw an arrow at the long end of the yield curve, says Randall Merk, senior vice-president of portfolio management for Benham Mutual. "That's where the market thinks rates will go."

ZEROS' POPULARITY. Most people ignore this signal and chase the highest-yielding bonds. For example, now that short rates are rising, short-term bonds look good. But a flattening yield curve means those tempting returns aren't likely to last and may leave investors having to reinvest at lower rates when these bonds mature. "What appears to be the least attractive option, that's what you should be doing," says FPA's Rodriguez.

Another plug for long bonds comes from comparing them with equities, which return 10% a year on average over the long term. With 8% Treasuries, you're getting awfully close to that return without the risk, as long as you have enough time to hold the bonds to maturity. Zero-coupon bonds look even better. Since they don't pay out interest until they mature, there's no risk you'll have to reinvest at lower rates if you hold them to maturity. Indeed, says Benham's Merk, money has been pouring into his zero funds for about two months. Because of their extreme price volatility, zeros are paying slightly higher yields than long bonds (15-year zeros yield some 0.16 of a point more than 30-year Treasuries).

COLLEGE GOAL. If last year's rout makes you skittish about long-term bonds, there are ways to hedge your bets. Stick with government bonds that, unlike municipals or corporates, have no credit risk. Choose maturities that coincide with a future goal, such as paying for college tuition or retirement. Or ladder your portfolio with bonds of different durations so that you always have some bonds maturing to reinvest at current rates.

Another option is to dollar-cost-average by investing a little bit during each of the next few months so you won't miss out if rates rise further. Investors with a long time horizon should lock in bonds each time they break 8%, says Bill Fish, an analyst at Donaldson, Lufkin & Jenrette. Whatever type of investor you are, you can't go too wrong putting 10% of your portfolio in a safe long-term investment paying nearly 8%.

The Lure of Long Bonds

EThe economy should start slowing in the first half of 1995, keeping inflation in check and causing interest rates to level off or drop

EWith inflation at 3% and yields close to 8%, a 5% real return puts bonds at the high end of their historical range

EAn 8% yield on Treasuries is close to the 10% historical average return on stocks, which are usually riskier

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