Getting the Most Out of Bonds

Low interest rates have hurt many retirees, who may be tempted by high yields. Big mistake, warn the experts, who offer some safer solutions

By Amey Stone

Sure, the Federal Reserve has given the economy a boost with 10 interest-rate cuts so far this year. But it has also whittled away at Americans' options for earning a decent income from safe investments. A one-year CD now yields just 2.17% on average while a money-market account brings a mere 1.8%, according to Bankrate.com. Lock up your money for 10 years in a U.S. Treasury bond and you get 4.9% a year.

"Everyone has talked about the crash in the stock market," says Alan Skrainka, chief market strategist at Edward Jones, a St. Louis brokerage. "No one is talking about the crash in interest rates as it relates to retirees. Lower rates may be good news for consumers who are shopping for a home or a car, but it has been a major setback for retired investors who depend on income investments to maintain their standard of living."

RESISTING TEMPTATION.

  That bad news also extends to investors who want to maintain a cushion in case the equity market heads south again, yet also seek to earn more than the 1.8% that the average money-market fund yields. The temptation in times like this is simply to "reach for yield," as Skrainka puts it. Like other strategists, he warns against doing so. Such tempting yield-grabbers as preferred stocks, global-income funds, or high-yield junk-bond funds are among his least favorite investments.

Even long-term government bond funds may be riskier than they seem. Chances are pretty good that rates will rise in the next few years, forcing down the value of bonds -- and the funds that hold them in the secondary market. In fact, rates have spiked unexpectedly in recent weeks. The 10-year Treasury, now at 4.9%, was at 4.2% on Nov. 7, and funds that invest in long-term U.S. Treasuries have lost money. "Initial signs are there that the economy is capable of bouncing back pretty aggressively and rates could run up," says Frank Koster, a fixed-income portfolio manager at Strong Funds.

Given the risks of reaching for yield, what follows are some no-risk to low-risk ways of increasing the income from safe investments.

For investors who don't want to take any risk:

Stick with CDs and money markets but shop around for the best deal. That's the advice of Greg McBride, a financial analyst with Bankrate.com, a free Web site that lists the highest yields for a variety of savings vehicles. For example, ING Direct is paying 3.44% for a money-market account and several banks are paying 3.6% for one-year CDs. The national average for money market funds is only 1.8%, but Merrill Lynch, Dreyfus, and HSBC have fund options yielding 2.5% or better, according to data from iMoneyNet.

Build a "ladder" of Treasuries. When you buy and hold bonds until maturity, you don't have to worry about the direction of interest rates. Locking in a 5% rate on a 10-year bond may not sound that appetizing, but there is plenty of value in the fact that you can bank on those payments and make plans in the knowledge that the check will be in the mail, says Robert Smith, president of Smith Affiliated Capital. If you "ladder" your portfolio -- buy bonds that come due in periods of one, three, five, and ten years -- you don't have to fret about being locked into low rates since some of your money will come due every two years. Should rates go up, that money can be reinvested at the new higher rates. Skrainka calls this his "No. 1 best strategy" for generating rising income.

If you don't need the current income but want safety, buy "Patriot" bonds. That's the new name for old-fashioned savings bonds, which will be available, starting in mid-December, at 4.07% (although the interest rate is reset every six months). You pay a penalty of three months' interest if you cash them within five years, but long-term investors get plenty of tax breaks. The interest on savings bonds grow tax-deferred for up to 30 years, and they are free of state and local taxes when you cash them. For people in a high-tax bracket in a state with steep local taxes, the tax benefits make the bonds comparable over time to other investments yielding 6%.

If you're willing to take a bit more risk:

Buy a short-term bond fund, preferably ultra-short. The shorter the maturity of the bonds, the less risk you face that prices will fall due to rising interest rates. Plus, the bonds roll over more quickly, so the money can be reinvested sooner if rates rise. There are three dozen funds termed "ultra-short bond funds" by Morningstar that are the next step out in risk from money market funds. Top-rated Strong Advantage (STADX ) has a duration of less than a year and some exposure to the corporate bond market, which Koster believes will give it an edge when the economy revives. It has returned 5% in 2001.

Consider municipal bonds, especially if you live in a high-tax area. Smith says municipal bonds are now a much better deal than Treasuries for individual investors' taxable accounts. Both a 30-year New York City bond and a 30-year Treasury yield about 5.35%. But because the New York City bond is tax-free, the tax-equivalent yield is 8.25%, points out Smith. Because it is important to diversify across a number of issues, small investors should go with a low-fee muni fund, he advises.

If you really want to take some risk to get that yield:

Buy high-quality corporate bonds. "Corporates are as cheap [relative] to Treasuries as they have ever been," says Strong Funds' Koster. The reason they're cheap is that default rates have been rising due to the weakening economy. But as the economy improves, corporate bond prices should do well -- even if they face a drag from lower interest rates. "It's very possible that the corporate spread contraction could more than offset the interest-rate exposure," adds Koster. The trick is to stay with investment-grade bonds. A high-quality corporate bond fund yields around 5.5% or 6%, says McBride. He agrees this is probably the best option for investors who need that level of income.

Look for rising dividend stocks. That might sound like heresy to fixed-income investors, but Skrainka suggests that companies -- and the mutual funds that invest in them -- with a history of increasing their dividends can be relatively safe and high-yielding. For example, many REITs (real estate investment trusts) pay 6% or better. He likes Equity Office Properties (EOP ). Also old-fashioned utilities like Southern (SO ) or Piedmont Natural Gas (PNY ) have yields around 5%. For fund investors, he recommends American Funds' Washington Mutual.

With rates this low, "bonds should be seen as a defensive investment as opposed to a means of achieving satisfactory returns over time," says John Lonski, chief economist at Moody's. And, with the economy still wobbly and a rebound in corporate earnings not yet in sight, building a safe income stream could be a good strategy if stormy times continue.

Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column

Edited by Beth Belton

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