Taking The Bafflement Out Of Bonds

Interest rates have been edging downward for nearly a decade. But since the Presidential election, newfound optimism over the budget has sent long rates tumbling. And with each down- ward tick, the bond market has shot up like the opposite end of a seesaw. As bond prices have risen, investors have been diving into the market. Is this a good idea? Have prices peaked? Should you be selling bonds? Or are there still good buys in this rock-bottom interest-rate environment?

Before it's possible to answer these questions, you must understand one of the basic principles of bonds:

Prices and interest rates always go in opposite directions. The bond's interest is fixed when you buy it, so the movement of interest rates in the economy will make your bond more or less valuable.

If you buy a $1,000 bond paying 10% and rates rise to 15%, investors will want the new issues that pay more, and your bond will lose resale value. If rates drop from 10% to 5%, your bond becomes more valuable than those subsequently issued. So you could sell it at a premium. These gyrations shouldn't matter if you hold a bond to maturity. Then, you'd just care about the amount of income it generates.

The great risk now is that interest rates are bottoming out and may soon start to rise. This could cause bonds to lose value on the resale market and lock long-term bondholders into low-paying investments. Traders who want to realize gains might consider cashing in soon.

HEDGES. If you want to buy bonds, you should hedge against rising rates. You can do that by sticking with short- to medium-term (one- to ten-year) bonds because their prices fluctuate less than longer-term bonds. "We're not buying anything long term," says Eric Ryback, president of Ryback Management Corp. in St. Louis, "because if we're close to the bottom, and you lock up stuff at 6.8%, you're going to be in trouble."

Another hedge is laddering: Buy bonds with staggered maturities so that part of your portfolio comes due, say, each year for ten years, providing cash you can reinvest short-term if rates are rising and long-term if rates are falling. "You don't lose sleep when you do it this way," says Dale Krieger, president and CEO of Carnegie Hill Co., a money management firm in Princeton, N.J.

Bond funds minimize risk by diversifying more broadly than most individuals can. Funds also require smaller minimums than individual bonds, are run by professionals, and allow you to reinvest small amounts of income in new shares. The downside: Because funds constantly roll over their investments, your principal isn't guaranteed at maturity as it would be with individual bonds. Instead, you get the value of the shares you own when you sell. So "funds will do more poorly in a rising interest-rate environment, and outperform bonds when rates are falling," says Jay Goldinger, an analyst at Capital Insight Brokerage in Beverly Hills, Calif.

Convertible bonds are another hedge. Ryback invests in companies where prospects are clearly improving. If the stock price goes up, he can convert bonds into stock, capturing equity gains, and escaping the risk of rising rates.

The low rates today's bonds are paying make them less desirable investments than in past years, but they still offer a better return than money-market securities. Supersafe two- and five-year Treasuries offer about 4% and 5.25%, vs. 3% for most money-market accounts.

To grab even more interest without locking your money into 30-year issues, con-sider higher-risk corporate bonds, says John Capodici, senior fixed-income manager at the investment management firm Glickenhaus & Co. To play it safe, stick with bonds rated aaa by Standard & Poor's or Moody's. Capodici looks to companies with an a to bbb rating--still considered investment grade--with rates of 1.5% to 2% above comparable five- to ten-year Treasuries. A few picks: Conseco, a mortgage-banking firm; Countrywide Credit Industries; and Toledo Edison Co., a utility.

Bonds rated less than bbb, or junk bonds, offer even better yields. The quality of junk bonds has increased, says

Capodici, but he advises buying them only with a good investment adviser or a reputable mutual fund.

GOOD BET? Munis remain a tremendous bond play. "The greatest value is still in tax-free munis," says Krieger of Carnegie Hill. "There are fairly generous aftertax yield spreads between munis and Treasuries--and taxes are sure to go up." He points out that a top-rated 20-year Virginia state muni is paying 1.4% more aftertax than a 30-year Treasury bond. Municipal zero-coupon bonds, which sell at a deep discount and only pay interest at maturity, could be a good bet--especially if you expect to need a chunk of money in the future, says Philip Barach, managing director of the Trust Company of the West, an investment management firm. Zeros are attractive if rates are falling because they reinvest your interest at the rate of the bond.

Barach also finds as much as 2% over Treasury yields in collateralized mortgage obligations (CMOs), instruments that slice up mortgage-backed securities such as Ginnie Maes into bonds maturing at various times. Your risk is that the mortgages will be prepaid or dragged out, depending upon which way interest rates head, so you have to be flexible about maturity.

The party may be over for bonds even though they still beat cash investments. The investors currently flooding the bond market aren't likely to see another huge runup in prices. But a discerning look will reveal a selection of less dramatic, still worthwhile deals.

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