The deck is stacked against bond investors as the recovery moves into its next phase. After a roaring 18 months during which bond prices soared in almost all categories, yields on just about everything are now miserable. U.S. Treasuries remain the least attractive part of the market. Yields on T-bonds are low, and their prices are highly sensitive to rising interest rates. Other high-quality sectors that tend to move in step with Treasuries -- such as agency-backed mortgages and high-grade corporate debt -- look unappealing, too.
One way to boost yield is to move into long-term bonds. You may be tempted to go that route because the gap between the yields of short- and long-term bonds is wide. However, choosing longer maturities means accepting significantly greater interest-rate risk (bond prices move in the opposite direction of interest rates). That's an unwise trade-off. By early 2011, the Federal Reserve is likely to begin raising short-term interest rates, a move that will probably result in higher long-term yields but also knock down bond prices.
A steep yield curve also signals that the economy is improving. That bodes well for weaker, low-quality companies, which typically need healthy economic growth to prosper. As the recovery has begun to look more durable, the team at Loomis Sayles Bond (symbol LSBRX) has ratcheted up the fund's exposure to high-yield corporate bonds. They now account for about one-third of assets, says co-manager Kathleen Gaffney. Tad Rivelle, co-manager of Metropolitan West Total Return bond (MWTRX), says he's finding the best value in mortgages not backed by a federal agency. It's a risky part of the market because these mortgages offer no government guarantee in case of default. That's why Rivelle prefers the most senior issues of these bonds (those that get paid first). "It's likely investors will be well rewarded for bearing the risks," he says.
Beyond such select pockets of value in the domestic market, the best opportunities among taxable bonds still lie abroad. Gaffney says that 30% of her fund's assets are invested in bonds denominated in foreign currencies. In addition to currencies tied to commodities, such as the Australian and Canadian dollars, she likes Asian currencies that should appreciate in line with the Chinese yuan, such as the Singapore dollar and Indonesian rupiah. If you don't already hold foreign bonds through a diversified fund such as Loomis Sayles Bond, now's the time to buy. An excellent option is Templeton Global Income (GIM), a closed-end fund managed by foreign-bond ace Michael Hasenstab (see Our Favorite Broker-Sold Funds).
Investors in tax-free municipal bonds should ignore the headlines proclaiming a coming apocalypse for state and local budgets. Additional credit-rating downgrades and even defaults among municipalities are likely. But, says Jim Colby, senior municipal strategist for Van Eck Global, "if any entity exists that is appropriately empowered to deal with these budget issues, it is state and local governments." With income-tax rates almost certainly heading higher, you can't afford to turn your back on munis.
Meanwhile, the rating agencies are reworking the way they score munis. Although the changes will do nothing to improve the quality of the underlying bonds, they should raise the average credit rating of the sector. This is not to say investors can ignore the risks in munis -- particularly considering that bond insurance is now a mere memory.
Unless you're confident in your ability to pick individual munis, you're probably better off buying a solid fund, such as Fidelity Intermediate Municipal Income (FLTMX), a member of the Kiplinger 25. Manager Mark Sommer has split the fund's assets between long-term bonds, to capture as much yield as possible, and short-term bonds, to mitigate the effects of rising interest rates.