Investment Consult: Making bonds pay off

March 21, 2003

Making bonds pay off

 

Investment Consult

By Lewis J. Altfest, CFP

Making bonds pay off

• Lower-rated corporate bonds look promising.

• Municipal bonds are free from federal taxes.

• Diversified bond mutual funds spread your bets.

 

Shell-shocked investors have been leaving the stock market for the relative safety of fixed-income investments, especially bonds. Unfortunately, returns on these vehicles are pretty paltry right now: Money-market funds currently return less than 1.5 percent annually, and 10-year US Treasury bonds pay a little over 4 percent. That makes for a slow road to wealth.

But you can earn greater returns on fixed-income investments if you're willing to take some prudent risks. Here's what I'm recommending to my clients.

BBB-rated corporate bonds. Lately, investors have passed over BBBs, which are lower-rated investment-grade bonds, in favor of higher-quality offerings (A minus to AAA). However, BBBs currently offer a return almost two percentage points better than Treasury bonds of similar duration. When the economy strengthens, BBB corporates could outperform Treasuries by an even wider margin.

Municipal bonds. Because they're free from federal taxes—and often from state and local taxes, too—munis can provide more-attractive returns than taxable bonds. For instance, someone in the 30 percent tax bracket would have to earn 7.1 percent on a taxable bond to equal a tax-free yield of 5 percent, which is what a lot of good long-term munis pay these days. (For municipals, I define "long-term" as 12 years or more.) Moreover, if a state-backed obligation gets into trouble, the state bails it out by charging its residents higher taxes.

Diversified bond mutual funds.These funds spread their assets among their choice of many different parts of the fixed-income universe, including US government bonds, corporates, high-yield ("junk") bonds, foreign bonds, and emerging market debt. One of the best is Loomis Sayles Bond Fund (800-633-3330). Its smart, talented managers take an aggressive approach to fixed-income investing and boast an excellent long-term record.

A second favorite of mine is Pimco Total Return Fund Shares (888-877-4626), run by legendary manager Bill Gross. Unlike Loomis Sayles Bond Fund, which owns a significant amount of below-investment-grade bonds, Gross primarily sticks with high-quality issues. He has a knack for mixing them in the right proportions to provide returns that generally exceed those of other diversified bond funds. The Class D shares are no-load and open to the public.

Stable-value funds. These funds, which pension plans have used for some time, own high-quality bonds, plus interest-bearing, guaranteed-return contracts sold by insurance companies, banks, or other financial institutions. According to the Stable Value Investment Association, investors receive interest income comparable to that earned on an intermediate-term, investment-grade bond, "but without the associated market risk." That's why the stable value industry often compares its products with money-market funds. But stable value funds deliver better yields, so they offer greater total returns than money-market funds. Investors do face some risk, however, if a contract issuer goes bankrupt. That's why stable value funds invest with many institutions.

A leading low-cost fund in this category is PBHG IRA Capital Preservation Fund (800-433-0051). Its five-person management team buys primarily AAA-rated, short-term bonds and has rewarded investors with a three-year average annualized return of 5.7 percent, and an impressive current yield of 4.4 percent. (Note: The fund charges a 2 percent redemption fee on shares held less than 12 months.)

Certificates of deposit. Returns on CDs that mature in three or five years can sometimes exceed those of US government bonds of the same duration. An excellent source for CD rates in your state is Bankrate.com ( www.bankrate.com). When examining the numbers, keep in mind that earnings on certificates of deposit, unlike earnings on government bonds, are subject to state and local taxes. So shoot for at least an extra percentage point of return from the CD.

Sometimes it pays to switch out of one certificate of deposit and into another. You'll pay a penalty to cash out of the old CD—usually equivalent to three-to-six months' interest—but it might be worth paying if rates rise by a few percentage points.

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. The ideas expressed in this column are his alone, and do not represent the views of Thomson Medical Economics. 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, 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: Making bonds pay off. Medical Economics 2003;6:33.