Bonds: The Picking Will Get Trickier

Bonds won't do as well they've done in recent years, but you can still find smart buys.

Bonds have enjoyed three boffo years, but don't expect a repeat performance in 2003. What's your best strategy? Seek out bonds with the best relative yields. In the high-quality arena, you'll find better value in Treasury Inflation-Indexed Securities (widely known as TIPS) than in plain-vanilla Treasuries. Tax-exempt municipal bonds and mortgage-backed securities are also excellent choices. For investors willing to stomach more risk, high-yield corporate bonds show perhaps the highest potential returns of all.

In 2002, the biggest worry in the bond market was credit risk as investors watched investment-grade players such as Enron Corp. and WorldCom Inc. go belly-up. Even when there are no financial shenanigans, a weak business climate usually leads to downgrades in credit quality. But as the economy snaps back, interest-rate risk becomes a bigger threat than credit risk.

To guard against erosion in the prices of bonds you own as rates rise, choose securities with shorter maturities. "You need to move in on the yield curve," says Robert V. Gahagan, head of taxable fixed-income investing at American Century Investments. He advises sticking with bonds that mature in seven years or less because if rates rise, the prices of the bonds will decline less than those of longer-dated issues.

Another way to protect your portfolio is to invest across fixed-income classes. To help you diversify wisely, here's what to expect in the different sectors.

HIGH-YIELD BONDS

There are good reasons why these securities, better known as junk bonds, yield a huge 8.81 percentage points over Treasuries with comparable maturities: widespread bankruptcies and fears that the fledgling economic recovery could stall out. Still, the income these bonds throw off may more than justify the risk.

For one thing, the percentage of outstanding junk-bond debt in default, which soared from 2% in 1998 to 9.8% in August, has begun to edge lower, to 8.7% recently--its lowest level since June, 2001, according to Moody's Investors Service. "We're already seeing a turnaround" says Margaret D. Patel, portfolio manager at Pioneer High-Yield Fund. She notes that the yield gap between junk bonds and Treasuries stood at a much wider 10.9 points in October, an indication that investors are beginning to wade back into the junk-bond market.

Patel argues that the yield gap will continue to narrow as the economy shows further signs of improvement in 2003. That's good for investors who already own the bonds since prices rise when yields fall. She says 30% of her fund's $3.6 billion in assets are invested in the debt of cyclical companies, including auto suppliers and industrial and transportation companies, which stand to benefit as the economy picks up steam.

MUNICIPAL BONDS

For the first time in 16 years, yields on top-quality munis are equal to or higher than yields on comparable Treasuries. Today, an AAA-rated 30-year muni yields 5%, vs. 4.9% for a 30-year bond. For an investor in the 30% income tax bracket, that means a 30-year muni yields an even juicier 7.1% after taxes.

Munis are carrying such high relative yields because, with interest rates so low, states and local governments have flooded the market with new supply. Mary J. Miller, assistant head of fixed-income investing at T. Rowe Price Group Inc. allows that budget woes are likely to lead to credit downgrades of some state and local governments, but she doesn't expect a serious wave of defaults. She also believes an improving economy will help municipalities get back on their feet. "We may be at the worst point in the cycle right now," says Miller.

MORTGAGE-BACKED BONDS

Securities issued by Fannie Mae (FNM ), Freddie Mac (FRE ), and Ginnie Mae offer plump yields that are about 1.8 percentage points above comparable Treasuries, plus high credit quality. (Only Ginnie Mae's are backed by the full faith and credit of the U.S. government. The other two are government-sponsored enterprises.) In contrast, notes American Century's Gahagan, high-quality corporate bonds, such as those issued by Wal-Mart Stores Inc. (WMT ) and PepsiCo Inc. (PEP ), outyield Treasuries by a scant 0.3 to 0.7 percentage points.

Sure, if rates rise, he says, the mortgage securities will suffer some price decline, but the overall return will still be strong because of the relatively higher yield. Then again, an uptick in rates will slow the pace of homeowner refinancings, which means that higher-yielding mortgage securities would more likely stay in investors' hands.

TREASURIES

Despite their reputation for safety, U.S. Treasuries are riskier than they've been in years. For one thing, the market is likely to see a gusher of new supply as Washington borrows to pay for a military buildup and to deal with tax-revenue shortfalls. "Treasuries are going from being scarce to being plentiful--and we are looking at federal budget deficits as far as the eye can see," says Daniel C. Dektar, chief investment officer at investment management group Smith Breeden Associates Inc.

That's not all. If interest rates rise, Treasuries will see more price erosion than other sorts of bonds because Treasury yields have fallen more sharply, says T. Rowe Price's Miller. "If you are buying Treasuries, stick with maturities of six months or less." That way, if rates rise, you can invest in higher-yielding bonds.

Another way to protect against rising rates is to invest in TIPS, as the Treasury's inflation-proof bonds are called. In addition to making semiannual interest payments, TIPS adjust their principal value twice a year to reflect inflation, as measured by hikes in the Consumer Price Index.

TIPS recently yielded 2.5%, vs. 4.1% for a 10-year Treasury, resulting in a "breakeven" inflation rate of 1.6%. That means inflation needs to remain above 1.6% over the next decade for TIPS to outperform conventional bonds. Since the inflation rate has averaged more than 4% annually over the past 40 years and is forecast to be 2.2% in 2003, TIPS seem to be an investor's best bet in the Treasury bond market.

By Susan Scherreik

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