When buying bonds, Arnold and Esther Kossoff play it safe. "We take our risks in stocks," says Arnold Kossoff, a 70-year-old retired Boca Raton (Fla.) real estate broker who invests mainly in munis and Treasuries. But many investors have shown less restraint. With long-term rates at historic lows, they've gone out on limbs in search of high returns. "When yield is the sole focus, investors often end up taking on more risk than they intended," says Mark Wright, Morningstar's fixed-income analyst.
Those risks can come from a host of different directions. For example, you need to pay attention to the time it takes your bonds to mature. Two-year Treasuries are yielding 5.37%. That's close to the 10-year rate of 5.63%. But the shorter-term bonds are less risky because longer-term debt is more susceptible to swings in the economy and interest rates. What's more, while junk and other lower-quality bonds are yielding more over Treasuries than they were last year, many pros don't think the extra percentage points are worth the risk. That's all the more reason you might want to think twice before plunging into fixed-income investments that look too appealing.
Some bonds have complex structures that make it hard to see where you could be tripped up. Take collateralized mortgage obligations (CMOs). These are derivatives backed by pools of AAA-rated, government-insured mortgages. That means your principal is guaranteed by the government. But in 1994, CMOs severely burned many small investors as interest rates unexpectedly rose. Since then, they've come roaring back. Some $150 billion worth were sold in 1997, up from $66 billion the previous year. That's in part because some instruments are yielding as much as 7.5%, nearly two percentage points over comparable Treasuries.
SURPRISE. Chastened by the 1994 debacle, brokers aren't selling CMOs as aggressively as they once did. But not everyone appreciates CMOs' potential downside. A quarter-point rate swing in either direction can deliver an unpleasant surprise, says Daniel Dektar, portfolio manager at Smith Breeden Associates.
If rates rise, the price of a CMO will fall, leaving a long-term, lower-yielding investment. If rates plunge, home refinancings and prepayments of mortgages underlying a CMO will speed up. You'll get some of your principal back sooner than expected and will have to find new ways to invest the cash at lower rates. In an added twist, many recent issues are doubly callable. This means that besides the prepayment risk, there's a chance that institutional investors with options on the underlying mortgages will call your entire issue. With these technicalities sure to bedevil individuals, "CMOS are not for the retail investor," warns Marilyn Cohen, president of Envision Capital Management, a Los Angeles-based fixed-income money manager. "They are for institutions that have the staff and the computers to understand the models."
Junk bonds are easier to comprehend and shine with mainstream acceptance. But they've become much chancier. "Bondholders have been lulled to sleep with 8% to 10% yields vs. 5% to 6% for Treasuries," says William Gross, managing director of Pacific Investment Management Co. High-yield bond funds returned 14.1% in 1996 and 13.2% last year, vs. 8.3% for all bond funds.
Gross, like many bond pros, recommends shunning domestic high-yield debt now. Lower rates will aid issuers, but that will be of little help if the economy slows sharply and defaults rise. He also worries that the fallout from Asia could jeopardize companies' earnings and ability to pay down debt. And if you want junk to provide a hedge against a stock market decline, think again. Junk prices tend to move in the same direction as stocks, so an equities bear market would also be a bear market in junk. "The yield spreads over Treasuries aren't high enough to compensate an investor," says Daniel Fuss, managing partner for fixed income at Loomis Sayles.
If you still want junk market exposure, you're safer investing in a mutual fund. Because funds own bonds of many issuers, your returns shouldn't be greatly affected if one defaults. BUSINESS WEEK's top picks (Feb. 9) include Fidelity Spartan High-Income, which delivered an average annual total return of 14.7% for the five years ended Dec. 31, and Mainstay Hi-Yield Corporate and Northeast Investors, which returned 13.8% and 15.2%, respectively.
Emerging market debt is another risky investment that has made its way into small portfolios, albeit indirectly. "Lots of emerging market bonds have gotten into fund portfolios in the last two years" to pump up yields and returns, says Morningstar's Wright. That worked well when such debt was soaring in '96 and part of '97. Now, faltering Asian economies are hurting the performance of funds with issues from around the world. For example, prices of emerging market Brady bonds have slid since the Asian crisis as their yields rose from 342 basis points over Treasuries to a recent 503. That socked the Legg Mason Global Government fund. It has about 26% of its portfolio in emerging market debt, mostly Latin American but some Korean and Indonesian issues. For the year ended Jan. 30, the fund returned 0.06%, vs. 4.89% for its peers. Even if you think the Asian countries will rebound, you may want to avoid much exposure to their debt since recovery may take longer than many expect, says PIMCO's Gross.
If you're supposed to avoid sexy, high-yield stuff, what's left for a good return? Many bond mavens follow Arnold Kossoff's strategy: investing in old-fashioned Treasuries. That may sound boring. But if you're going to lose sleep, reserve your angst for the stock portion of your portfolio, not bonds.