Last Updated Apr 6, 2009 11:36 AM EDT
Although stocks have bounced back in recent weeks, you’re only human if you’re still a bit wary. Maybe the latest rally is for real and stocks are screaming buys — but that's what you thought six months ago, before prices fell another 40 percent. Cash may feel more comfortable, but a typical money market fund will pay you a paltry 0.3 percent for that peace of mind. So are higher-yielding bonds still a smart and safe way to bet on the revival of the U.S. economy?
That's what you'll hear from a lot of strategists. After all, except for supersafe Treasuries, most bonds took a bath last year, as investors fled anything that didn't come with Uncle Sam's guarantee. Since a fall in bond prices causes a rise in bond yields, last year's losses make the yields on everything but Treasuries look especially enticing.
Today you can earn 7.4 percent on high-quality corporate bonds while you wait out the recovery. You can collect 3.2 percent pre-tax on intermediate-term tax-free municipal bonds, the equivalent of earning 4.5 percent on a taxable bond if you're in the 28 percent tax bracket.
But in both cases, there are downsides to consider. If you decide to invest in bonds today, you need to know the risks you're taking, the bet you're making, and the best way to buy.
The Trouble with Treasuries
If Treasuries have been such a success story, why not stick with what’s worked? Here’s why: Because they were too successful. When investors rushed into the safe arms of a U.S. government guarantee last year, Treasury prices soared and yields evaporated. You’ll earn a measly 0.22 percent (annualized) on the three-month T-bill now. Between the Federal Reserve’s recession-fighting rate cuts and the panicky investors flooding the market, Treasury yields are so low that prices have nowhere to go but down. (Bond prices and yields move in opposite directions.) “For the most part, today’s Treasury market is a place where the average investor can only lose money,” says 80-year-old Ben Jacoby, co-founder of Brinton Eaton Wealth Advisors and a veteran of the long bear market of the 1970s.
Going forward, the picture looks bleak for Uncle Sam’s bonds. To pay for the gargantuan stimulus package, the government will issue even more of them, flooding the market. “Yields will have to rise for those bonds to find buyers,” says Dan Fuss, vice chairman of fund company Loomis Sayles, and that will depress the value of existing bonds. Now that investors may have regained their appetite for stocks, it’s entirely possible that they’ll dump bonds, further driving up supply. Another threat to bond values is inflation, which, by reducing the future value of bond yields, also puts downward pressure on prices.
You might think that if the stimulus spending proves inflationary, you should take a look at Treasury inflation-protected securities, or TIPS. But those have low yields too, and Fuss isn’t upbeat about their prospects. “It will be a while before there is any inflation to protect yourself from,” he notes. “In the meantime, these securities are going to be volatile.”
Given all this, if what you crave is rock-solid government protection, your best bet for a smidgen of extra yield is a one-year certificate of deposit at an FDIC-insured bank. You can earn as much as 2.3 percent on one now. (Go to www.bankrate.com for the best deals.) With FDIC insurance, you’ll face no more than a little paperwork if your bank fails, as long as you stay below the depositor insurance limits. (See www.fdic.gov for details.)
Late last year, if you were willing to bet that capitalism wasn’t on the verge of total collapse, you could profit quite nicely by shifting money from Treasuries to investment-grade corporate bonds: The spread between the yields on 10-year Treasuries and high-quality corporate bonds hit five percentage points in December, up from less than two points at the beginning of the year. (Check out the “Treasuries vs. Corporates” chart for a look at the recent trends.) But just a few months later, those bonds no longer look as enticing. “The big opportunities in high-quality corporate bonds are gone already,” Fuss says. “There aren’t that many bargains to be found.”
What happened? Yield-hungry investors dumping ultrasafe but unprofitable Treasury bonds for corporates drove up prices and narrowed corporate bonds’ yield advantage over Treasuries a bit, but not by much: Today you’ll still pick up an extra 4.5 percentage points investing in high-quality corporate bonds versus 10-year Treasuries. The big difference is the deteriorating economic outlook. While you may earn more than 6 percent in some high-quality corporate bond funds, that may not be enough to make up for the risk that a deeper and more prolonged recession will drag companies down even more.
Jewels in the Junkyard?
For some, the solution, paradoxically, is to take more risks. These days, the only corporate bond bargains you’ll find are in high-yield bonds, or what’s commonly known as the junk bond market. Typical junk bonds are offering yields of more than 17 percent. “This is the part of the market where spreads remain astronomically wide,” says Cam Albright, managing director of fixed income management at WT Investment Management, a division of Wilmington Trust.
There’s a good reason for those lavish yields, of course. The risk you take with high-yield bonds is that the company will default on its obligations. That would wreak havoc both on the bonds issued by the individual company and on the market as a whole, as soaring default rates devastate market confidence. Not only is the default rate — currently hovering around 3 percent — expected to skyrocket to as much as 15 percent as the recession takes its toll, but the universe of junk bonds is poised to soar. Ratings agency Standard & Poor’s forecasts that 75 large global bond issuers are on the verge of losing their investment-grade rating and tumbling into junk bond status, the highest number in nearly two decades.
By buying a high-yield bond fund, you’re betting that defaults won’t go as high as some fear. “The default rate would have to be over 25 percent for high-yield bonds not to pay off,” says Rob Arnott, chairman and founder of investment management firm Research Affiliates. “That’s far higher than the rate reached in the Great Depression.”
Don Quigley, who manages about $5 billion in fixed income assets, including the $1.3 billion Artio Total Return Bond Fund, agrees: “Generally, the high-yield default rate has to be really high for a long period for high-yield bonds not to work out as an investment.”
As long as you’re comfortable with the risk, the best way to invest in high-yield bonds is through a low-cost diversified mutual fund with proven managers and experienced in-house credit research teams who can seek out the best opportunities and manage risk well. Top high-yield funds that meet those criteria include Fidelity High Income (SPHIX), T. Rowe Price High Yield (PRHYX), and Vanguard High-Yield Corporate (VWEHX), according to analysts at Morningstar.
If you want a much lower-risk way to dip a toe in corporate bonds, go with a diversified fund whose manager can invest in whatever bonds — Treasuries, other government bonds, corporates — are most attractive at the time. “Bill Gross at PIMCO now has about 25 percent of the assets of his Total Return fund in carefully chosen corporates,” notes Lawrence Jones, associate director of fund analysis at Morningstar.
The headlines are sobering: Municipalities around the country teetering on the edge of bankruptcy. California furloughing government workers to help close its budget gap. And the municipal bond insurance that once guaranteed principal and interest payments vanishing, another casualty of the financial markets meltdown.
For investors, the bad news translates into a rare opportunity: the chance to earn more on tax-free bonds than on Treasuries, and that’s before you take the tax savings into account. As you can see in the “Treasuries vs. Munis” chart, in recent months the yield on a 10-year high-quality muni bond has often topped 10-year Treasury yields. “Careful investors could find this a great buying opportunity,” says John Miller, chief investment officer for municipal bonds at Nuveen Investments.
Additionally, you avoid federal taxes (and sometimes state and local taxes) on the interest munis pay — one of the few free lunches left on Wall Street. If taxes go up in the next few years, as proposed, that benefit will become even more valuable. Today, the 4 percent yield you can earn in a tax-free fund is the equivalent of earning more than 5 percent in a taxable fund if you’re in the 28 percent tax bracket.
Still, there are no truly free lunches in the markets, the muni market included. Yields are historically high for a reason: State and local government finances are shaky, and that could lead to credit downgrades. Plus, you probably don’t have the time or inclination to do the considerable amount of credit research required to pick individual muni bonds since the demise of insurance that once guaranteed their value. And because many muni bonds don’t trade much, it could be hard to find a buyer for your bonds at their full price.
So most financial advisers recommend picking diversified municipal bond funds run by experienced managers. Top-rated low-cost picks from Morningstar include Fidelity Municipal Income (FHIGX), Vanguard Long-Term Tax-Exempt (VWLTX), and Fidelity Intermediate Municipal Income (FLTMX).