What's Next for Bonds
Use these strategies to protect your bonds from the coming storm.
By David Landis, Contributing Editor
From Kiplinger's Personal Finance magazine, July 2004
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When the Fed meets, bond owners tremble. And there'll be a lot of trembling this summer if, as expected, Alan Greenspan and his colleagues on the Federal Reserve Board begin pushing interest rates higher to smother inflation.
If history is any guide, the Fed's initial rate hike won't be its last. The last time the Fed began to ratchet up rates was in June 1999. By the time it was finished, the Fed had raised rates six times in 11 months, boosting the federal funds rate a total of 1.75 percentage points, to 6.5%. Currently, the rate is at a 46-year low of 1%. The federal funds rate is typically about two points above the inflation rate, which stands now at about 1.7%. So the federal funds rate has far to go before it reaches a "neutral," or normal, level of 3% to 4%, says Anthony Crescenzi, chief bond-market strategist for securities-trading firm Miller Tabak.
Investors, who determine longer-term interest rates through the sale and purchase of bonds, have beaten the Fed to the punch. The yield of the benchmark ten-year Treasury note, 3.1% when it bottomed in the summer of 2003, stood at 4.8% in mid May. Crescenzi says the ten-year rate should run 2.5 to 3 points above the inflation rate, which he expects will rise to 2%. That calls for a yield of up to 5% on the ten-year note by year-end. Crescenzi warns, though, that it could go higher. Crescenzi's analysis suggests that long-term bonds have already experienced the worst. But given the growing concerns about a pickup in inflation, we would advise against buying bonds with superlong maturities or funds that invest in such bonds. (Kiplinger's forecasts a 2.3% increase in the consumer price index in 2004.)
For fund investors who want to ride out the storm in the safest place possible, short-term bond funds offer the greatest protection from falling values. Of course, the catch is that they offer meager yields. As of mid May, for example, ultra-short-term bond funds (those with average maturities of a year or less) yielded just 2.1%, on average, according to Lipper, a fund-data company. A good choice among traditional short-term funds is Vanguard Short-Term Corporate (VFSTX; 800-635-1511). It yields 3%, and its bonds have an average maturity of 2.7 years.
If you're willing to take on more credit risk in exchange for better returns, consider junk-bond funds. After scoring big gains last year, high-yield, low-quality bonds are not particularly cheap. But junk bonds may hold up reasonably well as interest rates rise because their issuers stand to benefit disproportionately from an improving economy, says Milton Ezrati, an economist at mutual fund adviser Lord Abbett. The high-interest coupons of junk bonds also offer extra protection against rising rates. A worthy fund in this category is Northeast Investors Trust (NTHEX; 800-225-6704), which sports a yield of 7.2%.
Floating-rate income funds also hold up well when rates rise because they invest in corporate loans with adjustable interest rates. The risk is that issuers of adjustable-rate debt tend to be weaker companies. But the strengthening economy reduces the odds that these issuers will default. A solid choice in this category is Fidelity Floating Rate High Income (FFRHX; 800-544-8888), which yields 2.9% -- about 2.4 percentage points above the average money-market fund payout -- and allows you to redeem shares at any time (not all floating-rate funds do).
If inflation does accelerate, Treasury Inflation-Indexed Securities, or TIPS, will be a good bet. TIPS protect investors against inflation by periodically adjusting the principal for increases in the consumer price index. (Because interest payments are geared to the principal, they, too, are effectively tied to the inflation rate.) Ten-year TIPS yield about 2.2%, or 2.6 percentage points less than regular ten-year Treasuries. Buying TIPS represents a bet that annual inflation will be greater than the 2.6% of yield you pass up by not buying the regular ten-year Treasury note. If you hold TIPS in a taxable account, be aware that the periodic inflation adjustments to principal are taxable even though they are just paper gains. Note, too, that despite the inflation-adjustment benefit, TIPS tend to behave like long-term Treasuries, falling in value when rates rise. So funds that focus on TIPS are fairly volatile.
Another way to temper risk is to invest in tax-free municipal bonds. These bonds should benefit from the improving financial condition of state and local governments, which reduces the bonds' credit risk. Our favorite muni bond fund, Vanguard Intermediate-Term Tax Exempt (VWITX), has an average maturity of 5.9 years and yields 3.4%. That's the equivalent of a taxable 4.7% yield for an investor in the 28% federal- income-tax bracket.
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