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Buy Bonds Now
High-quality corporate and municipal bonds are great ways to make money without taking much risk. But act now. The bargains won't last.
By Steven Goldberg, Contributing Columnist, Kiplinger.com
January 13, 2009
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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.
Reader Comments (10)
Posted by: Jerry at 01/13/2009 06:08:00 PM
You mentioned Vanguard Intermediate-Term Investment Grade (VFICX) as a good choice and the fund should lose less than 5% if rates rise one percentage point. Would the yield be reduced by 5% or would the amount you have invested be reduced by 5%? Could you explain this with an example?
Posted by: Beth at 01/14/2009 10:46:00 AM
Just a reader...for best advice contact your Financial Advisor: Bonds have a few important terms to know. Face Value = the amount on which interest is paid. Market Value = the amount the bond is worth in the current market; this is the amount you would buy or sell a bond for. Interest Rate = the % rate the issuer is paying you to borrow your money; this is paid on the FACE VALUE. Yield = the interest rate divided by the current market value. And, Total Yield or Return = the return if you factor in both the interest rate and any change in market value...Bonds have an inverse (opposite) relationship between interest rates and bond prices or market value. Bonds can sell at "Par", "Premium" or "Discount". Par means dollar for dollar. Par is usually $100. Premium means more than $100 so you might pay $103 in market value for every $100 face value that you get e.g. pay $10,300 in market price for $10,000 of face value. Discount is then less than $100 e.g. pay $9,200 market price for $10,000 face value. SO, for example if you had $10,000 cash to buy a bond TODAY you might buy a Corporate Bond that pays 6% interest on your $10,000. Let's say you bought this bond at Par value so you paid $10,000 in market price for $10,000 in face value: dollar for dollar. Say this bond you're buying has a 15 year maturity so it will mature in 2024. Now even though that Bond matures in 2024, the corporation could choose to pay you back early after a certain timeframe has passed (think of you refinancing your home mortgage after the bank's prepayment penalty period has passed) OR you could sell that bond in the market. During those 15 years that you might hold that bond, interest rates will vary. For example, 3 yrs from now interest rates might be 9%. Then someone with their own $10,000 in cash to invest would rather buy a brand new bond paying that 9% than buying your bond for the same $10,000 and only get 6%. SO, 3yrs from now, the "Market Value" of your bond would be less than $10,000 ...how much less depends on several factors but the most obvious is the difference in the current interest rate and the rate you're getting or the 9% and the 6%. So if you were to sell that person your bond they would buy from you at a "Discount" and you would have a capital loss (though you did get interest payments those 3 yrs).
Posted by: Beth at 01/14/2009 10:47:58 AM
Just a reader continued…Let's say you decided not to sell and after another 2 years pass (5 total) interest rates have dropped to 4%. Now, someone with $10,000 in cash buying a new bond would only get 4% so your 6% is looking pretty nice. And if they wanted your 6% they would have to pay a Premium to get it so they would pay more than $10,000 and you would have a capital gain if you sold. As a side note, this also might be a good time for that corporation to refinance their debt and lower their cost of borrowing from 6% to 4%. They would simply put out a new bond issue at 4%, new investors would loan them money at 4% and the corporation would use that new money to pay back you and your fellow bond holders currently getting the 6% rate. Ok, let's get back to you and your bond. Yield then, in this example, is the set 6% interest rate divided by the varying market prices the bond has over time. For Par yield is 6% / $100 = .06 (or 6%); For Premium yield is 6% / $103 = .05825 (or 5.825%); For Discount yield is 6% / $92 = .06521 (or 6.521%). Changing yields does not change the real dollar amount of interest payment you receive because that is always paid on Face Value. Yield is typically used a tool to evaluate whether or not the bond is a good value because it is a way to compare bonds that might all be selling at different market prices with different interest rates. In Bond Mutual Funds, think of the above example but with hundreds of bonds all with their own Face Value, Market Value, Interest Rate, Maturity and Yield. You then have an investment with a lot of moving parts that is averaged out to give you an overall Market Value (NAV), Interest Payment, Yield, and Total Return. Very often with bond funds, the term yield is used to describe the current average Interest Rate of all the bonds in the fund and Total Yield or Total Return is used to describe the increase "premium" or decrease "discount" in market value (NAV) from the average Face Value of all the bonds along with the average interest rate. So when the author is talking about a 5% decrease, he is talking mostly about the likely decrease in market value (NAV) as interest rates or rather inflation (which directly impacts long term interest rates) rises as the economy heats back up and goes into recovery mode. Inflation is simply put the rising cost of goods and services. Watch out for those oil prices to rise quickly when the world economies kick back in! Good luck!
Posted by: Steven Goldberg at 01/14/2009 01:54:14 PM
Jerry, hi, it's Steve Goldberg, author of this column. The price would fall by 5%. The yield would stay the same. So if the fund had a net asset value of 100 and yields on similar maturity corporate bonds rose by one percentage point, the fund's NAV would fall to 95.
Posted by: jmillst at 01/14/2009 03:29:13 PM
for (Jerry), the amount of principle invested would decline by 5%
Posted by: John at 01/16/2009 11:57:20 PM
In my 401(k) I have two choices in bond funds. There is a mid-term bond fund and a "longer term" bond fund. I've got about 20 yrs until retirement. My question is, since bond fund values decline as interest rates rise, and interest rates are close to zero(right?), isn't it a bad time to buy bond funds. What am I not understanding? I'm new to all of this so any insight is appreciated.
Posted by: Steve Goldberg at 01/23/2009 01:09:45 PM
John, hi, this is Steve Goldberg, author of this column. Bond math is tricky, and you've got it right. But there's one other factor at work. In a deep recession, such as the one we're in, prices of many corporate bonds fall because investors fear that companies may not be able to pay back what they've borrowed by issuing bonds. When that fear begins to subside, corporate bond prices rise. Hope this helps readers understand bonds better.
Posted by: Ellen at 05/06/2009 03:41:15 PM
I bought several Washington Mutual corporate bonds a couple of years ago. They have since defauled. Is there any way I can recoupe any of my original investment? Thanks.
Posted by: Fred at 05/09/2009 07:16:31 PM
I am 62 and will be retiring Jan. 2011. I am about 90% S&P 500 (Fidelity) and 10% Bonds. Of late, I have ONLY been putting $ into the Fidelity money mkt acct. (effective yield after exp is about 0%). When do you think it would be safe to go into intermediate term bonds mutual fund. I have this $ in the Fidelity Individual Annuity and my ONLY real choice is FTLKC? Thank you.
Posted by: Steve Goldberg at 05/11/2009 12:40:48 PM
Fred, hi, this is the author of this article. The Fidelity Intermediate Bond fund is a terrific one. I'd invest in it now. The non-annuity version yields almost 5% and has an expense ratio of just 0.44%. Fidelity does a fine job with bonds. I don't recommend them more often only because I think Vanguard generally charges less and sticks to higher quality bonds. Hope this helps.