Bonds: Reading the Yield Signs

Two years ago, fixed-income markets made little distinction between long- and short-term risks. A 6-month Treasury bill yielded approximately 5%, roughly the same as a 30-year bond—what is known in economic-speak as a flattened yield curve. Times have changed. Now, the 30-year bond commands a yield roughly 3.5 percentage points higher than its shorter-dated cousin, as investors seek a premium for holding longer-term debt.

That may sound like a good thing. But even with the spread, are investors in longer-term debt issues being fairly compensated for taking more risk? The answer is probably not.

Right now, the U.S. Treasury and the Federal Reserve are doing everything in their power to prevent deflation, the widespread drop in prices that is seen as a far greater economic peril than inflation, by flooding the markets with money. The government has juiced the money supply through a massive issuance of new Treasury securities. All that cash will eventually lead to a boost in inflation (though the timing of when prices will start to accelerate is anyone's guess). That's a bad thing: Inflation causes bond yields to rise and prices to fall, especially at longer maturities.

Even at the Fed's inflation target of 2%, current rates appear too low. At historical spreads to a 2% consumer price index, the 10-year Treasury should trade at 4.75%, not its current 2.9% yield, and 30-year mortgage rates should be around 6.25%, not 4.5%. If and when inflation does return, those bonds will plummet in value. "You will have inflation take hold," says Thomas Girard, portfolio manager of the Mainstay Balanced Fund. "The yield curve will steepen, and that's negative for longer-duration assets."

But in the inflation-deficent present, fixed-income investors are wondering where they can turn for a meaningful yield. Rates are pitifully low at the short end of the curve, especially in U.S. government debt, where the yield on a 6-month T-bill is now only 0.32%. Short-term municipal bond rates aren't much better, with the average 6-month AAA-rated general obligation municipal bond yielding 0.34%. But if investors are willing to take on a little credit risk, they can juice their returns in a meaningful way. Here's a look at some smart strategies for the main fixed-income categories:


U.S. government debt serves one purpose in this environment—safety. And the safest place to be is the short end of the yield curve, say in 6-month T-bills. Investors can either buy individual bonds via (Treasuries are probably the only bonds investors can buy without getting hit with high fees), through bond funds like the Vanguard Short Term Treasury Fund (VFIRX), or Treasury exchange-traded funds like the iShares Barclays 1-3 Year Treasury Bond Fund (SHY).

But safety comes at a price: Those T-bills yield just a third of a percent. Ten-year Treasury notes, on the other hand pay interest of around 2.9%. Under normal conditions, rates tend to fluctuate and if an investor had to sell the 10-year before maturity, he'd risk taking a loss if rates moved higher. But these aren't normal conditions. The Fed wants to keep rates low, so every time the 10-year rate creeps up toward 3%, the central bank steps in and starts buying bonds, driving the price up and the yield down.

For the time being, at least, that makes the price very stable. Investors should be able to buy in at around 2.9% and sell, if necessary, at around the same price. So instead of buying short-dated Treasuries, why not buy the 10-year and collect the extra yield while government policy keeps rate fluctuations in check? The one downside is that investors must pay attention to signals from the Fed that it's no longer willing or able to keep the 10-year bond below 3%. When that happens, it's time to sell, sell, sell.


Munis are the one area where it may be worth venturing further out on the yield curve. For starters, they're offering historically high rates relative to Treasuries. Under normal conditions, muni yields have been roughly equal to 85% of a Treasury bond. Today, a top-rated 10-year muni yields 3.27%—1.1 times the current yield on the 10-year note. If investors look to A-rated bonds, two notches down from the top category but still investment grade, that ratio jumps to 123%. And that's before any tax advantage is factored in. At the top tax bracket, that 3.27% yield effectively becomes 4.88%.

Even more adventurous investors could look to the 30-year muni, like California's recent general obligation offering that came with a 6.1% interest rate. That jumps to over 9% with the tax advantage factored in, a good rate no matter what inflation does. "If the tax position is right," says Matt Freund, vice-president of fixed income investments at USAA, "munis are something to look at."

But longer maturity bonds have more risks than some investors might want to take, especially if they have to sell before the bond matures. Rising interest rates will force the price down. So will a downgrade from a credit rating agency. Tax revenues are falling, and that puts still more pressure on municipalities. Even priced with the higher yields, says Tom Atteberry, co-portfolio manager of the First Pacific New Income Fund, longer-dated munis are just not worth the risk. "In the muni market you have credit quality concerns that are just starting to show themselves," he says. "We don’t see where you’re getting paid to take the risk."

High-Yield Bonds

The current economic environment makes these lower-rated issues even more risky than usual. A recent study by Moody's (MCO) predicted that defaults would hit 16.4% of all junk-rated debt by the end of 2009, well above the recessions in 1991 and 2001. But junk bond indexes currently yield 16%, roughly pricing in Moody's forecast. And if defaults prove to be less than advertised, the price of the bonds will go up as well.

Individual investors shouldn't try to cherry-pick junk issues on their own, however. USAA's Freund, who is also co-portfolio manager of USAA's High-Yield Opportunities Fund (USHYX) recommends sticking to mutual funds—diversification is key—and then to those featuring maturities of two to three years. Right now, those funds yield between 10% to 12%—at least nine percentage points above an equivalent Treasury. "They offer great returns for investors with a two-to-three year horizon," says USAA's Freund.

Investment-Grade Corporates

High quality is nice when investing in corporates. Government backing is even better. Put the two together and you may have a winner. Take a company like General Electric (GE). Despite recent downgrades of its debt from its lofty triple-A perch, the credit-rating agencies still have GE rated well into investment grade. GE Capital, the company's financing arm, recently issued FDIC-backed debt with an interest rate of 1.8% that matures in two years—0.87 percentage points better than the equivalent Treasury.

But for a little more risk, investors can boost their yield even more. Forfeit the FDIC protection, says Don Galante, senior vice-president of fixed income at MF Global (MF), specialty broker of futures and options, and yields jump another percentage point. However, investors need to make sure that the bond matures before the FDIC-backed debt matures, and the FDIC's willingness to back such debt comes to an end, so that GE will have a source of capital to pay back principal even under difficult conditions. A good choice could be a GE bond that matures in 18 months, purchased with a yield of 3%.