Investment Consult: Best buys in bonds

July 23, 2001

With the stock market sputtering, now&s a great time to look at quality fixed-income investments.

 

Investment Consult

Best buys in bonds

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With the stock market sputtering, now's a great time to look at quality fixed-income investments.

By Lewis J. Altfest, PhD, CFA, CFP

After the stock market experienced a disappointing 2000, a lot of my clients asked me, "What about bonds?" I responded that I've always believed bonds should be a part of every portfolio. That includes yours—and now's a great time to shift some money into bonds.

Why now? For one, I expect that demand for bonds will remain strong as investors wait for stocks to rebound. In particular, government-backed, municipal, and corporate bonds issued by safe, established companies will be in great demand, because many investors will become more fearful of defaults if the economy slows further.

With these things in mind, here's a rundown of some particular types of bonds you might consider now, along with my recommendations for mutual funds that invest in them.

Low risk

Inflation-indexed bonds. Yes, inflation could rise even in a slowing economy. To neutralize its effects, buy US Treasury Series I savings bonds. These combine a fixed annual interest rate with a percentage that reflects the most recent inflation rate. Until October, you can buy Series I bonds that will pay 5.9 percent for six months.

Banks sell Series I bonds, and you can also order them on the Web. Go to www.publicdebt.treas.gov; under "Savings Bonds," click on "Buy Direct!" If you'd rather own inflation-indexed securities through a mutual fund, so a professional manager can monitor the maturity dates and reinvest your earnings, I recommend the no-load Vanguard Inflation-Protected Securities Fund.*

Ginnie Maes. Yields of regular government bonds have declined sharply, but Ginnie Mae mortgage-backed securities are yielding nearly 7 percent these days, at least a percentage point more than a 10-year Treasury bond. Issued by the Government National Mortgage Association, Ginnie Mae bonds are fully backed by the US government. That means you'll receive principal and interest payments even if a rash of mortgage holders default on their loans.

Because the frequent principal and interest payments that Ginnie Maes throw off can be murder for you or your accountant to track, I recommend investing in these bonds through funds. Two inexpensive no-loads that I like are American Century GNMA Fund­Investor Shares and Vanguard GNMA Fund. Their 10-year average annualized returns are 7.4 and 7.7 percent, respectively. (All fund returns are through May 31.)

Moderate risk

Corporates. High-grade corporate bonds are attractive now, because their yields are generally greater than those for government bonds of comparable maturity. Stick with corporate bonds rated A or better by Moody's Investors Service (www.moodys.com ) or Standard & Poor's (www.standardandpoors.com ), the two leading ratings services.

A broker who specializes in bonds can recommend quality corporates; you can also do your own research at a Web site such as BondsOnline (www.bondsonline.com ). If you use a broker, you'll pay a one-time commission, but not the annual fees that mutual funds charge. However, to keep commissions as low as possible, I suggest you buy bonds that trade on the New York Stock Exchange. These trade frequently, so brokerage fees are likely to be smaller than for bonds that trade over the counter.

Still, a mutual fund has its place for those who prefer diversification and professional management. I recommend Harbor Bond Fund and Vanguard Intermediate-Term Corporate Bond Fund. Managed by acclaimed fixed-income specialist Bill Gross, Harbor Bond has a 10-year average annualized return of 8.7 percent and requires a mere $1,000 initial investment ($500 if the fund is held within an IRA). Vanguard Intermediate-Term Corporate returned 14.9 percent in the past 12 months, placing it in the top decile in its category. It requires a $3,000 investment; $1,000 for IRAs. Both no-load funds charge little in expenses.

Convertibles. You can exchange convertible bonds, also known as converts, for a set number of stock shares of the same company. The conversion feature is simply a way of making the bonds more attractive to investors. The resulting investment falls about midway between a bond and the company's common stock in terms of risk, price fluctuation, and total return.

Because of the intricacies of convertible bonds, you'd do well to let a mutual fund manager pick them for you. My no-load choice is Fidelity Convertible Securities Fund. It has a superior 10-year average annualized return of 16.7 percent and carries a five-star overall rating from Morningstar.

High risk

High-yields. In 1991, when investors realized that the rate of defaults on high-yield issues was likely to decline, high-yield-bond mutual funds took off and returned more than 37 percent on average, according to Morningstar. I'm not saying you'll earn that much, but I do think high-yields will outperform most other bond categories over the next several years, barring a deep recession. Default rates should peak this year or next, and the overall quality of new issues is apt to rise.

Also known as junk bonds, high-yields are often issued by speculative companies—those, for instance, that are small and unproven or in emerging foreign markets. Junk bonds' generally higher yields are your compensation for accepting a significantly greater risk of default. To lessen this risk, invest in a fund of high-yields. Two no-loads at the top of my list are Northeast Investors Trust and Vanguard High-Yield Corporate Fund. They have annualized 10-year returns of 10.9 and 9.5 percent, respectively.

Foreign bonds. The last two calendar years have been miserable for international bonds. Within that category of mutual funds, those that use options and other investment strategies to hedge their foreign currency exposure against the dollar have done better than their peers. That's because the dollar has been strong relative to most other currencies.

However, if the US economy weakens and the dollar declines, a mutual fund that doesn't hedge against the greenback will outperform others in the international-bond category. A low-cost no-load that takes an unhedged approach is T. Rowe Price International Bond Fund, which holds a comforting 86 percent of its assets in AAA- and AA-rated issues.

Editor's Note: Here's how to contact the fund families whose products are mentioned in this column: American Century (800-345-2021), Fidelity (800-544-8888), Harbor Fund (800-422-1050), Northeast Investors (800-225-6704), T. Rowe Price (800-638-5660), Vanguard (800-662-7447).

*For more on this fund and on inflation-indexed bonds, see my Sept. 18, 2000, column, "Don't let inflation deflate your portfolio".

The author, a fee-only financial planner, is president of L.J. Altfest & Co.( www.altfest.com ), a financial and investment advisory firm in New York City. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics magazine, 5 Paragon Drive, Montvale, NJ 07645-1742. You may also send a fax to 201-722-2688 or e-mail to meinvestment@medec.com.

 

Lewis Altfest. Investment Consult: Best buys in bonds. Medical Economics 2001;14:18.