Best Buys in Bonds

They're poised for big payoffs without big risks.

By Jeffrey R. Kosnett, Senior Editor

Elizabeth Ody, Associate Editor

From Kiplinger's Personal Finance magazine, March 2009

Suddenly, bonds are the talk of the investing world. while investors continue to fret about prospects for the stock market, they have concluded almost unanimously that the deals in the bond market are too good to ignore.

And despite a rollicking recovery that began late last year and continued into 2009, most sectors of the bond market (Treasury bonds being the notable exception) still offer good value. After all, what's not to like about corporate bonds paying 5% to 6% and tax-free municipal bonds paying 4% -- especially when inflation, one of the biggest enemies of bond investors, remains tame? And you don't even have to dip into junk-bond territory to get these returns.

Over the past year, bonds experienced the kinds of spills, chills and thrills that are usually reserved for stocks. Frantic selling on the part of nervous investors, unraveling hedge funds and others fueled some big losses. Investment-grade corporate bonds lost 7% on average in 2008; junk bonds lost a whopping 26%; and even ho-hum municipal bonds surrendered 4%. Meanwhile, a tremendous flight to safety inflated a bubble in the Treasury market. In December, the yield of the benchmark ten-year Treasury note bottomed at a whisper above 2% -- its lowest yield ever (bond prices move inversely with yields).

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Investors finally began to correct for some of these excesses late last year. But even after this turnaround, it still pays to stock up on bonds. Fixed-income investors face "a fertile, if challenging market," says Tom Dugan, co-manager of Dodge & Cox Income fund. "There are both great opportunities and land mines out there."

To sidestep those mines, avoid the riskiest categories for now. There's too much economic uncertainty to justify jumping into junk bonds or emerging-markets bonds. "You still want to be in very high quality," says Mark Kiesel, a portfolio manager at Pimco, the big bond manager.

But Treasury inflation-protected securities and high-grade municipal and corporate bonds all offer a superb balance between yield and safety. Read on to find opportunities within each of these sectors.

In determining how much you should invest in bonds, balance your time horizon and risk tolerance. For an investor whose goal is more than ten years away, a 10% allocation is standard. If you're five years away from your goal, consider putting 30% to 40% of your portfolio in bonds. If you've retired, an allocation of at least 50% is reasonable, depending, again, on your risk tolerance.

The way you invest in bonds matters, too. Mutual funds are attractive for ease of use, but purchasing individual bonds insulates you from swings in their market price. (To learn about the risks of owning bonds, turn to the box on page 26. If you want to simplify things with a one-stop solution, see our all-in-one fund picks. In addition, download our rankings of 210 of the largest bond funds.)

Sweet deals in corporates

A powerful rally in prices of high-quality corporate bonds that started around Halloween should extend well into 2009. As a result, investment-grade corporates should deliver total returns of at least 8% this year and possibly more than 10%. That represents a remarkable turnaround from last fall, when prices for bonds issued by sound companies such as Deere and Wal-Mart tumbled and yields soared well beyond those of Treasury bonds with comparable maturities. These bonds lost value because of fallout from the credit crunch and turmoil among securities firms, which traditionally are major buyers and sellers of corporate debt.

Thanks largely to the Federal Reserve Board, the corporate-bond market is returning to normal. John Jansen, a former Wall Street bond trader and the author of a blog called Across the Curve, says that as long as the Fed keeps money cheap (its key short-term interest rate is effectively zero), yield-hungry investors will "scour the landscape" for corporate bonds rather than book a sure loss of purchasing power in low-yielding Treasuries. That realization is responsible for a 13% rise in price for the Dow Jones Corporate Bond index between November 1 and January 9.

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