2001FINANCIAL GUIDE

Where bonds are headed—and why you need to go there

With the stock market so volatile and interest rates poised to fall, bonds are looking better than they have for some time.

By Tim Begany

Now's a great time to buy bonds, though the bond market has been depressed for quite a while.

That makes no sense, you say? Marilyn Cohen, president of Envision Capital Management, a fixed-income firm in Los Angeles, offers some background: "We've had a horrific time in the bond market since last year because Federal Reserve Chairman Alan Greenspan kept raising interest rates." Since bond prices and interest rates move in opposite directions, the rate hikes caused the overall bond market to have a slightly negative return last year, as measured by the Lehman Brothers Aggregate Bond Index.

But the picture could improve dramatically over the next 12 to 18 months. While some bond experts foresee additional interest rate hikes by the Fed in the immediate future, most experts think that rates have just about peaked and are ready to decline. "A fall in rates would provide more upside potential for bond portfolios than we've seen in at least a year," says Al Zdenek, a financial planner and investment adviser in Flemington, NJ.

Why buy bonds when stocks rule?

This year's extreme stock market volatility has many investors giving bonds a closer look. But when you consider that buy-and-hold stock investors have historically enjoyed higher returns, you might wonder why you need bonds at all.

"It's a personal choice," says James Lee, a financial planner and bond specialist with Lau & Associates in Wilmington, DE. "People have to decide for themselves whether they want to eat well or sleep well. Stocks put good food on the table, but bonds let you sleep at night."

Of course, that's not all bonds are good for. They help diversify your holdings. And because they're usually much less volatile than stocks, they're a good stabilizing force in a portfolio. Finally, they provide a fixed amount of interest income. So if you need cash, it makes sense to keep a portion of your portfolio in bonds.

A variety of opportunities

When buying bonds, the first step is to ask yourself whether you want individual issues or shares of a bond mutual fund. If the current value of your overall investment portfolio isn't at least $250,000, go with mutual funds. Otherwise, you won't have enough money to diversify properly.

There are five main types of bonds and bond funds—US government, municipal, corporate, high-yield, and foreign (see "Bond types, and how to buy them.") Each category has attractive opportunities, though foreign bonds "can be very risky," Zdenek says.

If safety's a high priority, US government bonds (Treasuries) are for you. Currently, those with shorter maturities are most attractive, because the Fed's rate hikes have dramatically raised short-term interest rates. Furthermore, government buy-backs of Treasuries with longer maturities have caused long-term interest rates to decline markedly. As a result, in recent months the usual pattern for Treasury yields—higher with long-term Treasuries, lower with shorter-term—has been reversed.

Although the more traditional pattern may now be making a comeback, so far investing for longer terms still offers little or no benefit. For example, the average 30-year Treasury now yields only about 5.9 percent annually, the same rate five-year Treasuries offer. "Investors can still get more current income off the short-term stuff," Lee says. For good returns with high liquidity, consider very short-term Treasuries, he says, such as the three-month T-bill, which is now yielding more than 6 percent.

With yields of roughly 5 to 6 percent for issues with high credit ratings, tax-free municipal bonds may not seem worthwhile at first glance. However, for investors in at least the 28 percent tax bracket, those yields can work out to be better than Treasuries' and other taxable bonds', once you calculate savings for federal, state, and local income taxes.

For instance, in the 36 percent bracket, federal taxes reduce the yield on a 10-year Treasury with a 5.75 percent coupon to 3.7 percent. Finding high-quality municipal bonds of similar duration that pay better interest isn't difficult, Lee points out. If you pay state income tax, buy from the state you live in to maximize the tax advantages—unless you live in California. Because the supply of munis is inadequate there, yields on these bonds have dropped compared with munis from other states. California residents may therefore do better with out-of-state municipal bonds.

A bad time for junk picking

Now isn't the greatest time for high-yield, or junk, bonds. The Fed's rate hikes have boosted the cost of revolving credit, causing a number of companies to go belly up. For this reason and others, the risk of default is excessive for companies with intermediate or low credit ratings. "In this sector, things will probably get worse before they get better," predicts Marilyn Cohen.

But if you like adventure, consider putting some money in a junk bond mutual fund for when things do start to improve—in, say, 12 to 18 months, Cohen projects. "Those who stick it out may be rewarded with some very nice double-digit returns," she says.

Right now, however, you're probably better off with high-quality corporate bonds, which offer enticing yields relative to comparable Treasuries. A two-year bond from General Motors Acceptance Corporation, for example, pays about 7 percent annually, compared with 6.1 percent for a two-year Treasury.

A particular hot spot is the financial sector, because yields there are somewhat juicier than in other industries, says Cohen. She especially likes the 10-year bonds Goldman Sachs issued on Jan. 28 with a 7.8 percent coupon.

The author is a freelance writer in Trumansburg, NY.

Individual bonds or bond funds?

If you've got at least $250,000 in your portfolio, the choice between individual bonds and a fund depends on the type of bonds you want. For instance, you're best off buying Treasuries and highly rated municipals individually, because these bonds have such low risk. Since they don't require constant monitoring by fund managers, why pay the management fee that's charged to fund shareholders?

"However, active management is necessary for corporate bonds and intermediate- or mid-quality municipals," says bond specialist James Lee of Lau & Associates in Wilmington, DE. With these issues, a mutual fund is preferable, he adds.

Bond expert Marilyn Cohen of Envision Capital Management in Los Angeles has a narrower use for bond funds. She thinks you should stay away from them unless you're buying higher-risk issues such as junk bonds. "With individual bonds, you know exactly what your income will be," she points out. "That's not true with a bond fund."

If regular, predictable income is your top priority, by all means buy individual bonds. However, if you have less than $250,000 in your portfolio, if you're not that concerned about current income, or if you simply don't want to pay a broker to find the best individual bonds for you, consider funds (see "Consider these bond funds" for recommendations).

Bond types, and how to buy them

Although you can buy some individual bonds on your own, most municipal and corporate issues require you to go through some sort of brokerage. But that's not necessarily a bad thing. Buying from a broker is wise if you're a beginning investor who isn't comfortable making your own bond selections.

Do-it-yourselfers should consider Internet brokerages such as Ameritrade (www.ameritrade.com) and E*Trade (www.etrade.com), which offer a wide selection of bonds and very competitive transaction and sales charges. "But you have to know what you're doing," cautions bond expert Marilyn Cohen of Envision Capital Management in Los Angeles. "No one is there to help you make the right choice."

There are five main types of individual bonds:

US government bonds, or Treasuries, are the least risky. That's because the likelihood of losing your investment is practically nonexistent. However, because of their safety, Treasuries pay low interest rates, or coupons, which vary according to the bond's maturity (the date you get your investment back). You pay federal tax, but not state or local taxes, on this interest.

Though you can purchase Treasuries through bond brokers, the least expensive way to buy them is directly from the government through its Treasury Direct program. This saves you transaction and sales charges. For information, call your local Federal Reserve Bank or visit the US Bureau of the Public Debt's Web site (www.publicdebt.treas.gov/sec/sectrdir.htm).

Municipal bonds, which are issued by state and local governments, carry more risk than Treasuries—slightly or significantly more, depending on the bond's quality. They're most popular among high-income earners, because their interest is free of federal income tax. If you buy munis from your home state, you won't owe state or possibly local income tax, either. Because of their tax advantages, munis usually pay lower interest rates than Treasuries.

Corporate bonds represent a significant step up in risk from Treasuries and munis, because there's a markedly greater chance of default. That's particularly true if the issuer is an unknown smaller company. For the added risk, you can usually expect to earn at least a percentage point or two more than Treasuries in annual interest, all of which is subject to federal, state, and local income taxes.

High-yield bonds, also known as junk bonds, are very chancy, because they're issued by companies that have less than stellar credit or operate in unproven industries. They generally offer very high annual interest rates of around 10 percent and commonly generate returns comparable to those of stocks. Like regular corporate bonds, they're taxed at the federal, state, and local levels.

Foreign bonds are issued by sources outside the US. They carry high default risk (especially bonds issued by politically unstable emerging nations), the possibility of poor exchange rates, and a greater likelihood of securities fraud due to less stringent regulation of foreign securities markets.

To buy individual foreign bonds, you'll need help from a knowledgeable broker. If your broker doesn't deal in them—and many don't—ask for a referral to a firm that does.

 Consider these bond funds

All of the mutual funds listed below have good short- and long-term records relative to their peers, as well as reasonable fees and operating expenses. "A critical component of bond fund performance is the management fee," stresses James Lee, a financial planner and bond specialist with Lau & Associates in Wilmington, DE. The slimmer that fee, the better your fund's performance, since a smaller portion of its total return is used to pay the manager. For that reason, you may want to give special consideration to bond funds from Vanguard, which is well known for rock-bottom management fees and top-notch results.

 

Timothy Begany. Where bonds are headed--and why you need to go there. Medical Economics 2000;21:95.