Opportunity Rocks in Bonds
You can get good yields without taking much risk. But beware of Treasuries.
By Elizabeth Ody, Associate Editor
From Kiplinger's Personal Finance magazine, January 2009
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Academics tell us that the old saying about the Chinese word for crisis also meaning opportunity isn't really true, but the sentiment is alive and well in the bond market. After a year in which panic-fraught selling tugged everything from emerging-markets debt to supersafe municipal bonds into negative territory, there are now bargains aplenty for bond investors.
The stampede to safety in the bond market inflated the prices and crushed the yields of Treasuries. The past three weeks have seen yields plunge to lows not seen in the past half-century, partly on the Federal Reserve’s suggestion that it may buy up Treasuries to keep yields low. On December 5, the ten-year note yielded a paltry 2.7%.
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Meanwhile, deflation has replaced inflation on the list of near-term economic woes. Low Treasury yields tend to accompany deflation, which drives investors to the safety of government debt. Deflation would be a mixed bag for non-government debt, as lower prices and lower profits tend to increase defaults.
Stick to high-quality stuff. "We know that 2009 is going to be terrible, that the economy is in a deep recession and that bond defaults will go up," says Mark Vaselkiv, manager of T. Rowe Price High-Yield fund. Fortunately, you don't have to take on much additional risk to earn a nice, fat yield.
You can still find value among bonds backed by the full faith and credit of the U.S. government, in particular in Treasury inflation-protected securities, or TIPS. Although recession and falling commodity prices are holding inflation in check for now, efforts by governments around the globe to jump-start their economies may be seeding big-time inflation down the road. Given that backdrop, TIPS look cheap. TIPS feature an interest rate that is fixed at issuance, but their principal (and therefore interest payments) adjusts to keep pace with inflation, as measured by the consumer price index.
Compared with Treasuries, TIPS are a bargain. Investors measure the risk-reward trade-off of TIPS by looking at the break-even rate, or the yield difference between TIPS and ordinary Treasuries. That difference signals the inflation rate at which TIPS become the better deal. On December 5, ten-year TIPS yielded 2.2%, for a break-even rate of just 0.4%. That means TIPS will be a better deal than Treasuries over the next ten years if inflation surpasses 0.4% a year. That's a good bet.
However, the principal amount adjusts with deflation, too, so avoid TIPS that mature in the next five years. When TIPS mature they return either their original principal amount or this “adjusted principal” amount—whichever is higher. You won’t face a loss of principal if there’s serious deflation, but you could miss out on better deals elsewhere.
You can buy TIPS directly through www.treasurydirect.gov, or through a low-cost fund, such as Vanguard Inflation-Protected Securities (symbol VIPSX). The fund, which yields 3.4%, lost 4.1% in 2008 (all 2008 returns and yields are through December 5).
As strange as it sounds, mortgage-backed bonds are one of the safest asset classes around—not sub-prime, but agency-sponsored mortgages that conform to certain loan limits and that were made to buyers whose incomes were properly vetted. “When the government placed Fannie Mae and Freddie Mac into conservatorship, its implicit guarantee of their mortgage-backed bonds became an explicit guarantee,” says Todd Cohen, chief investment officer of Community Capital Management.
Despite that safety net, the bonds yield substantially more than Treasuries. In early December, both Ginnie Mae mortgage-backed bonds, which have always benefited from an explicit government guarantee, and Fannie Mae securities yielded 4.7% -- or 2.1 percentage points more than Treasuries.
For a pure play, Fidelity Ginnie Mae (FGMNX) is a fine choice. The fund gained 5.2% in 2008 and yields 4.9%.
But the best way to tap the market's sweet spots is probably through a flexible fund, such as Harbor Bond (HABDX). It is managed by Pimco mastermind Bill Gross, who has a knack for astute market calls. The fund, which at last word had 79% of its assets in mortgage-backed agency bonds, lost 0.8% in 2008 and yields 5.4%. It is a member of the Kiplinger 25.
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