Take a Short Ride on the Rate Wave
The best strategy for bond investors in 2006 is to stick with maturities of two years or less.
By Katy Marquardt, Staff Writer
From Kiplinger's Personal Finance magazine, January 2006
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Bigger may be better, but sometimes shorter is sweeter. For the coming year, bond investors should think short to minimize the chance of sour results.
Interest rates are finally starting to make sense. Long-term rates remained consistently low for most of 2004 and 2005, despite a dozen Fed-engineered short-term rate hikes. The result: a flat yield curve, with scant difference between yields on long- and short-term debt. But investors, who set long-term rates through their trading of bonds, are growing more concerned about inflation and are starting to push up bond yields. The yield on ten-year Treasuries, which was 4.6% in mid November, should hit 5.25% by the end of 2006. The short-term federal funds rate, recently 4%, should peak at 4.75% by spring.
Given the outlook, your best strategy is to stick with maturities of two years or less. That advice applies not just to Treasuries but to "every flavor and species of bond," says Paul O'Brien, a fixed-income portfolio manager at Morgan Stanley. By keeping maturities of individual bonds short, you'll be able to reinvest soon at higher yields. And if you invest in bonds through mutual funds, you'll experience smaller price drops in a short-term fund than you will in a long-term fund. (Bond prices move inversely with yields, and the longer a bond's maturity, the more volatile its price movements.)
You could do a lot worse than buying a six-month certificate of deposit, the most generous of which yields 4.4%. With the Fed likely to keep raising rates, you stand a good chance of being able to reinvest in six months at a rate that's three-fourths of a percentage point higher than today's yield. Among mutual funds, Vanguard Short Term Investment Grade (symbol VFSTX; 800-635-1511) returned 5% annualized over the past five years to November 1 and recently yielded 4.4%.
Tax-free municipal bonds tend to hold up relatively well when rates rise. On average, triple-A-rated munis maturing in 20 years yielded 4.5% in mid November. That's the equivalent of a taxable yield of 6.7% for someone in the 33% federal income-tax bracket.
Don't count on exciting returns from junk bonds. You don't get much extra yield for the additional risk -- on average, junk bonds yield only four percentage points more than ten-year Treasuries -- and the chance of default will rise as the economy slows.
For higher yields, look into emerging-markets bonds. "The risks are here in the U.S., and the real opportunities are in investing away from the U.S. dollar," says Kathleen Gaffney, a bond-fund manager at Loomis Sayles. TCW Galileo Emerging Markets Income (TGEIX; 800-386-3829) has turned in solid results, gaining 16% annualized over the past five years. It recently yielded 6.9%.