Buy Bonds Now
Okay, I know the headline makes me sound like a salesman on an infomercial. But it really is time to move the money from underneath the mattress. Treasuries, bank certificates of deposit and money-market funds offer puny yields. They are, in a word, unattractive.
Stocks are appealing at their current levels, but the road to higher prices will be bumpy, and stocks are, of course, much riskier than high-quality bonds.
After taking a horrible beating, stocks are now priced for a bitter recession. In other words, stocks should rise from here unless the economy worsens even more than most economists and market strategists expect.
At their lows in late November and early December, bonds had discounted a depression. If the future brings anything rosier than that, their prices, which have already started rising from earlier lows, should appreciate further (that will lead to lower yields because bond prices move inversely with yields). Investment-grade corporate bonds could easily return 10% or more this year.
Most investors shouldn't put too much of their money into bonds. After all, stocks have returned an annualized 10% since 1926 while bonds have returned only about half that. When the economy turns around, stocks are bound to do better than bonds.
But if you're nearing or are already in retirement, you ought to have 40% to 50% of your money in bonds. Bonds don't bounce around in price the way stocks do -- plus, they're priced to give you fine returns over the next year or so.
"Bonds have one-third the volatility of stocks," says Mark Kiesel, head of investment-grade bonds at Pimco. "I can earn 7% to 10% on corporate bonds and take one-third the risk of stocks." Bargains also abound among tax-free municipal bonds.
For several years, Pimco favored Treasuries and safe mortgages securities. "But six months ago, we began aggressively investing in high-grade corporates," says Kiesel, who sees the economy bottoming in the third or fourth quarter of the year and then beginning a gradual recovery.
Meanwhile, despite the recent rally, you can still find investment-grade corporate bonds with maturities of 15 to 20 years yielding more than 6%.
But yield is hardly the whole story. The prices of corporate bonds have been beaten down as a result of the credit crunch and concerns about the health of the economy. The differences in yields between Treasuries and most other bonds are higher than they have been since the 1930s.
Robert Auwaerter, head of fixed income at Vanguard, is as bullish as Kiesel on bonds. Bonds have rallied some, "but there's still plenty of opportunity in this market," he says.
Where to turn
Auwaerter recommends short- and intermediate-term bonds. Assuming the federal government is successful in pumping up the economy, inflation is sure to follow -- and that will hurt long-term bond prices.
The best bond fund for those investing in taxable accounts is Vanguard Intermediate-Term Tax Exempt (symbol VWITX). It yields about 4%, the average quality of its bonds is a supersafe double-A, and annual expenses are just 0.15%. If interest rates rise by one percentage point, the fund's net asset value per share should fall only about 5.5% because the fund owns very few long-term bonds. [Editor's note: Kiplinger's Personal Finance prefers Fidelity Intermediate Municipal Income, a member of the Kiplinger 25, although the two funds are practically indistinguishable.]
The Vanguard fund is a no-brainer -- unless you're in the 15% tax bracket or lower, in which case you should buy a taxable bond fund (see below). Residents of states with high taxes should also consider Vanguard single-state municipal funds, although such funds offer less diversification than national muni funds.
States and localities that issue muni bonds will come under increasing pressure as the economy continues to weaken. But historically, municipal defaults have been rare. And even when local governments do default, investors usually recover all their money -- eventually. Meanwhile, muni prices, like those of corporate bonds, are depressed -- and will rally as the market anticipates an economic recovery.
This is not the time to buy individual bonds. A fund gives you instant diversification and the ability to sell at a fair price every day. Many holders of individual bonds found they couldn't sell last year-except at ridiculously low prices.
Nor is this the time to buy junk. High-yield "junk" bonds yield about 17% on average. But they are issued by companies that stand a good chance of defaulting, particularly in this weak economy. The number of high-yield issuers defaulting on their debt is sure to soar, and investors caught holding defaulted bonds may not recover much of their money.
On the other side of the quality spectrum, stay away from Treasuries. Uncle Sam is sure to repay his debts, but investors seeking safe havens have pushed Treasury prices up -- and yields down -- to ridiculous levels. In truth, the only bubble in the current market may well be in Treasuries. When yields start to rise, Treasury prices will fall, and they may fall hard. "I wouldn't touch them," Auwaerter says.
In a tax-deferred account, Harbor Bond (HABDX), managed by Pimco, is a terrific choice. The average rating of its holdings is triple-A, expenses are reasonable at 0.56%, and the fund should lose just 5% or so if interest rates rise by one percentage point. It yields just under 5%. [Harbor Bond is a member of the Kiplinger 25.]
Willing to take a bit more risk? Vanguard Intermediate-Term Investment Grade (VFICX) is a good choice. Average credit quality is still high at single-A, expenses are just 0.21%, and the fund should lose less than 5% if rates rise one percentage point. It yields just under 6%.
More risk-tolerant investors should mix in Loomis Sayles Bond (LSBRX), even though this fund owns some junk bonds (see Take a Chance on Loomis Sayles Bond). I trust its managers to separate the wheat from the chaff, even in junk land. [Loomis Sayles Bond is also a member of the Kiplinger 25.]
Steven T. Goldberg (bio) is an investment adviser and freelance writer.