When Buying Bonds, Stick to the Middle

Bonds with medium-term maturities are your best bet as interest rates rise. These four bond funds should fare well this year.

From Kiplinger's Personal Finance magazine, January 2005

By now investors should know better than to try to outguess the bond market. Since the Federal Reserve Board began jacking up the short-term federal funds rate last June, the yield on the benchmark ten-year Treasury note has fallen to 4% from 4.8%. So anyone who bailed out of bonds last summer missed out on a nice rally (bond prices move inversely with interest rates).

Look for more of the same in 2005. Even if the Fed continues to push up short-term rates, long-term rates, which are set by inflation-wary investors, won't necessarily follow. Why? Because inflation remains in check. "I don't see it as a big problem," says Mario DeRose, a bond strategist at the Edward Jones brokerage. "As long as that's true, bonds should hold up pretty well."

Funds to consider

Short-term bonds hold their value better than longer-dated issues when rates rise. But the extra yield you get by extending maturities is worth the extra risk. Your best strategy now is to focus on bonds with medium-term maturities. Two fine funds that focus on such bonds are Dodge & Cox Income (symbol DODIX; 800-621-3979) and Harbor Bond (HABDX; 800-422-1050). Both hold a mix of high-grade corporates, Treasuries and mortgage debt. Each returned an annualized 8% over the past five years to November 1. Dodge & Cox yields 3.6%, and Harbor, run by highly regarded Pimco, yields 2.0%.

For those who prefer individual IOUs, DeRose suggests a Lehman Brothers bond with a 4.8% coupon maturing in 2014. Rated A by Standard & Poor's, at current prices it yields 4.6% to maturity. Marilyn Cohen of Envision Capital suggests the A-rated 5.5% bond issued by drugmaker Wyeth that matures in February 2014. It yields 5.3% to maturity. This is a so-called step-up bond: The interest coupon adjusts upward if a rating agency downgrades its ranking of the bond. Neither bond is callable.

If you're worried about a pickup in prices, consider Treasury inflation-protected securities. TIPS offer a return that is linked to rises in consumer prices. But with ten-year TIPS recently yielding 1.7%, they're not much of a bargain now. Unless inflation averages better than 2.3% annually over the next decade, you're better off with regular Treasury notes.

An alternative to TIPS is a floating-rate income fund. These funds invest in corporate loans with adjustable rates; as rates rise, so do payouts. Floating-rate loans are typically offered by companies in financial difficulty. Barring an economic calamity, though, a rash of defaults is unlikely. A good choice in this category is Fidelity Floating Rate High Income (FFRHX; 800-544-8544). The fund, which yields 3.1%, hasn't had a negative month since October 2002, its first full month in existence.

Lure of munis

Investors who are in the 25% tax bracket or higher should consider tax-free municipal bonds. "It's the best place to be for virtually any taxable account," says Robert Millikan, head of fixed-income investing at BB&T Asset Management. An excellent muni fund is Vanguard Intermediate-Term Tax-Exempt (VWITX; 800-635-1511). It yields 3.1% -- the equivalent of a taxable 4.3% yield for an investor in the 28% federal tax bracket -- and returned an annualized 6% over the past five years.

If you prefer individual munis, consider an insured Pennsylvania general-obligation bond with a 5.25% coupon that matures in October 2014. It yields 3.6% to maturity, which is equivalent to a 5% taxable yield for a taxpayer in the 28% federal bracket. If you want a shorter maturity, look at the 5% New York City general-obligation bonds due in August 2010. The bonds, rated A by S&P, yield 3.3% to maturity, equivalent to a taxable 4.6%.

--David Landis

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