Getting the Most Bang Out of Your Bonds

As with stocks, diversification can protect your portfolio

Do you think bonds are frumpy? Well, consider this. Prices for short-term U.S. Treasuries surged 9.1% between January 1 and Oct. 29. Other top-notch bonds have done as well or better. Investment-grade corporates are up 11.2%, and insured municipal bonds returned 9.1% on a tax-adjusted basis for investors in the 35.5% tax bracket. That performance is particularly impressive in light of the Standard & Poor's 500-stock index's 18.3% decline during that time and the 31.2% meltdown in the Nasdaq.

Now that your interest in interest-bearing investments has been piqued, watch out. The bond market isn't as treacherous as the Nasdaq at 5,000, but it's becoming a lot less appealing. On the safest investments, you won't earn much interest. Aggressive monetary easing by the Federal Reserve--nine cuts since January--has helped to drive yields on short-term U.S. Treasury securities to their lowest levels in decades. And for long-term bonds, the bigger risk could be higher interest rates.

For many, the antidote for low short-term yields is to invest in longer-term government bonds or even to buy corporates. But while bonds with the longest maturities yield the most, they also lose the most in value when interest rates rise. How much? Jeffrey Kleintop, chief investment strategist at PNC Advisors in Philadelphia, uses this rule of thumb: For every one percentage point that interest rates rise, the price of a 30-year bond would fall nearly 13%, vs. 7% for a 10-year issue and 4% for a five-year issue. Kleintop, for one, thinks rates will be moving up next year, and so suggests that investors in U.S. government bonds stick to issues maturing in five years or less.

Corporate bonds, both investment-grade and high-yield--or "junk" bonds--have had their problems. So far this year, according to S&P, 603 companies have seen their credit ratings slashed, and junk-bond defaults are expected to reach 9.5%, the highest level since 1991. But if the economy strengthens next year, corporates are likely to fare better than Treasuries. Sure, there'll be some downward price pressure from rising rates, but a healthier economy also portends more bounteous cash flows and improved credit quality.

Take the same diversified approach to bonds as you do with stocks. Blend in U.S. government, corporate--both high-quality and high-yield--and perhaps even foreign government debt. If you're investing taxable dollars, consider tax-exempt muni bonds. And it doesn't hurt to layer in some inflation-indexed bonds. Says Amy Falls, global fixed-income strategist at Morgan Stanley: "Genuine safety comes from thinking of all the possible investment outcomes and preparing for them."

In the high-quality arena, the best opportunities are in the debt issued by U.S. government-sponsored groups such as Fannie Mae (FNM ), as well as the mortgage-backed securities guaranteed by Ginnie Mae, Fannie Mae, and Freddie Mac (FRE ). Kevin Cronin, chief investment officer for fixed income at Putnam Investments in Boston, says deals in mortgage-backed securities are the best in years.

TEMPTING. Thanks to worries that homeowners will prepay mortgages amid sliding interest rates, these securities recently yielded 2.1 percentage points more than five-year Treasures. That's up from a 0.9-percentage-point spread in January, and the widest it has been since the 1989 savings and loan crisis, he says. Cronin, who sees higher interest rates next year, believes mortgage refinancings won't be as plentiful as feared. Securities issued by Fannie Mae, backed implicitly by Uncle Sam, are also tempting because they yield 0.6 percentage point more than five-year Treasuries.

The investment-grade corporate bond market offers bargains, too, says Stephen Kane, a co-manager of Metropolitan West Total Return Bond Fund. Since September 11, amid concerns that the economic slowdown will be deeper than previously expected, investors have bid up prices of financial companies and dumped bonds in the auto and travel-related sectors. As a result, Kane says the bonds of players like Ford Motor (F ) and General Motors (GM ) offer good value, with yields recently 2.8 percentage points above 10-year Treasuries, up from 1.9 points in early September. "They have enough flexibility to ride out the downturn," he argues.

Many bond pros think junk bonds offer the best plays. In the past month, prices have been pummeled by worries about deteriorating credit quality. The average junk bond recently traded for 75 cents on the dollar and yielded 13.4%, nine percentage points more than comparable U.S. Treasuries, the widest gap since the 1990 recession. "That extra yield compensates investors for expected increases in corporate bankruptcies and credit downgrades," says Margaret Patel, manager of the Pioneer High Yield Fund.

When the economy shows signs of recovery, Jack Malvey, chief global fixed-income strategist at Lehman Brothers, expects junk bonds to rebound. "The biggest bond story for 2002 will be high-yield," he says. But Patel cautions investors to avoid troubled sectors such as telecom.

It's tough for individuals to buy junk bonds on their own because institutions dominate the market and many issues are sparsely traded, making it difficult to sell them quickly. So look for high-yield funds that go light on bonds in telecom and other distressed sectors.

Lastly, you should inflation-proof your bond portfolio. It may seem silly to think about inflation at a time when most economists think we're in a recession. Morgan Stanley's Falls says the potential for inflation is remote when the world's economies are struggling. Still, PNC's Kleintop warns that the war against terrorism, thought to be a drag on the economy, could spark inflation if it leads to an oil supply disruption.

So consider buying a type of U.S. savings bond that is indexed against inflation. Series I Bonds were recently yielding 5.92%. I Bonds can be cashed out after five years and accrue interest for 30 years. They earn a guaranteed annual rate, recently at 3%. A second rate, recently 2.88%, is pegged to the inflation rate. The bonds are exempt from state and local taxes but not from federal taxes.

Bonds may not be the answer to all your investment woes. But holding a variety of bonds can bring your portfolio some stability in these unstable times.

By Susan Scherreik

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