Bond Investors Go To Extremes

Good values lie at both ends of the yield curve

Many bond investors are still licking their wounds after one of the worst years in recent memory. Now they may be staring at a window of exceptional opportunity. Federal Reserve Chairman Alan Greenspan is raising short-term interest rates to cool a torrid economy. Normally, that pushes up long-term rates, too. But because the government is using its budget surpluses to buy back long-term debt, yields on 10- to 30-year Treasury bonds are heading south instead. This phenomenon calls for new and super-selective strategies.

The ideal bond play offers both high income and capital appreciation. And fixed-income experts these days are finding that the best values lie at the extremes of the yield curve. So they recommend structuring your portfolio like a barbell--loading up on short-term bonds on one end and long-term debt on the other. Ken Volpert, a senior portfolio manager who oversees $17 billion in Vanguard Group bond index funds, explains that in terms of total return, a barbell portfolio will beat one concentrated in intermediate debt. That's because when the yield curve is flattening, the yield at "the middle is going to go up more than a blend of the ends." As intermediate yields rise, of course, the bonds' price will fall.

So which bonds do you pick? At the far end of the curve, good old 30-year Treasuries are looking like a better buy every day. You lock in a yield of around 6% from the safest issuer in the world. Meanwhile, as Washington keeps scarfing up these bonds, their value will rise. Volpert expects that because of their "scarcity premium," they'll appreciate more than long-term corporate bonds for several years. If 30-year government yields fall by a percentage point, to 5%, over the next 12 months, the 6% Treasuries you bought today for $5,000 will be worth $6,072.50, for a total return of 8.23%.

The falloff at the far end of the yield curve has created another opportunity: highly rated, tax-exempt, long-term municipal bonds. Like the federal government, the local entities that issue them are cutting back on debt. According to Randy Smolik, chief analyst at Municipal Market Data in Boston, muni borrowing in the first quarter is running about 35% below last year's levels. And on average, AAA munis are paying 96% of Treasury yields, compared with 87% a couple of years ago. The result: A high-grade, long-term muni can offer returns better than those from long Treasuries--without the tax liability. Assuming your tax bracket is 31%, such a muni returns as much as a taxable bond yielding nearly 9%.

FINE ART. Short-term rates, meantime, look likely to keep rising, perhaps by 50 basis points in the next few months. But some short-term bonds may offer price appreciation even in the face of that. High-yield debt has been hammered in the last couple of years as investors have moved into tech stocks. So managers are finding value in corporate and municipal junk bonds. For individuals, the safest way to play this market is probably via bond mutual funds, since dissecting the risks and returns of specific issues is a fine art.

Besides being cheap, high-yield bonds have another plus in a barbell portfolio: diversity. Their performance tends to ignore what's happening with government interest rates, because their yields depend almost entirely on default risk. Says Brad Tank, director of fixed income and portfolio manager at Strong Funds in Milwaukee: "High-yield securities often demonstrate incredible insensitivity to what's going on in the Treasury market."

It's not that hard to narrow the junk field. One no-load choice that's diversified and has beat the odds in a tough environment is the Columbia High Yield Fund. With an average current yield of 8.51%, the fund boasts an annualized average three-year total return of 6.06% through Mar. 3. Manager Jeff Rippey's biggest holding is Unisys junk bonds paying 11.75%--and he is adding to his position.

Many short-term junk funds focus on munis--naturally, since local governments and agencies that need to raise quick cash often get below-investment-grade ratings for their debt. After months of neglect, "we're seeing really good demand from retail investors," says Wayne Godlin, whose $1.45 billion Van Kampen High-Yield Muni A fund in January won Morningstar's Fund of the Decade Award in its category. Godlin specializes in tax-free munis rated BB or lower, with average yields of 6.48%. He has packed his fund with such issues as Richmond (Va.) development bonds paying 8.75% and Alexandria (Va.) debt paying 6.375%.

Another fund attracting attention from value investors is Heartland Short-Duration High-Yield Muni, which wins the unusual description of "high return/low risk" by looking for rich tax-free income but balancing its junk bonds with slightly higher-graded munis. Its managers like so-called lifecare bonds--from developers of retirement communities in Texas, for example--paying upward of 8%. The fund's 0.62% expense ratio makes it one of the better picks in the high-yield muni group, and its modest total return of 0.03% in 1999 beat Lehman Brothers' Muni Index by more than three percentage points.

Aficionados of convertible bonds are sniffing value, too. Convertibles are relatively short-term investments by definition--most have three-year maturities. Typically issued by growth companies, these bonds allow investors to exchange them for stock. In return for an income stream from the debt, you give up some appreciation potential on the equity.

BACKSEAT NO LONGER. Like munis, convertibles took a backseat to stocks when the equity bulls were running their hardest. Now, demand is picking up. One top performer is the Pilgrim Convertible A fund, which gave its investors a 50.63% return in 1999. Its managers' strategy: Focus on bonds paying in the neighborhood of 6% from fast-growth media companies such as Qualcomm and MediaOne Group.

Of course, if you mainly look to short-term interest rates for yield, the simplest investments may be the most attractive. Regional commercial banks, ever eager for new customers, are taking advantage of the uptick in short-term rates to tickle savers' fancy. The latest wrinkle in marketing bank certificates of deposit is the online auction, in which banks let investors bid for CD rates. For example, Pittsburgh's PNC Bank is offering three-month CDs at Visitors plug in how much they want to buy and the lowest annual percentage rate they're willing to accept. The bank is currently setting 10% as the maximum yield. The lowest APR submitted wins--even if it's higher than the current 6.03% national average for three-month CDs.

What happens to your strategy if the odd-shaped yield curve doesn't flatten any further? More experts are saying it's a good time to get back into bonds anyway. The Fed seems set on taking more wind out of the stock market's sails. And New Economy-type equities are so expensive that bonds represent good value by comparison. "Smart money now might want to take a few chips off the technology [stock] sector and reassign assets into the fixed-income market," says Van Kampen's Godlin. That's probably good advice even if you don't manage to make your holdings a perfectly shaped barbell.

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