Bargains Still Abound in Bonds

Mark Twain once noted that if you eat a live frog every morning, you'll tackle the rest of your day with the happy knowledge that the worst part of it is over. Similarly, investors can take comfort knowing that the panic that fueled devastating declines in bond values in late 2008 is a thing of the past. Money is again flowing into riskier parts of the bond market. Buyers and sellers are coming into balance. And the growing gap between short-term and long-term interest rates suggests that the economy is getting healthier -- a plus for issuers of corporate and municipal debt.

Investors are beginning to rebel against low Treasury yields. The yield on the benchmark ten-year note rose by 0.15 percentage point, to 3.3% on May 7 (a huge move by bond standards), when a $14-billion auction of 30-year notes drew weak demand. But until the Federal Reserve curbs its program of purchasing Treasury and mortgage debt in an effort to help home buyers by keeping rates low, yields probably won't climb much. "We're stuck in a range of 2.5% to 3.5% on ten-year Treasuries," says Kathleen Gaffney, co-manager of Loomis Sayles Bond (symbol LSBRX), a member of the Kiplinger 25.

You'll find better deals elsewhere. Investment-grade municipal bonds remain an attractive option for taxable accounts, despite having already rallied by nearly 8% in 2009 through May 8. At that point, the average intermediate-term, investment-grade muni yielded 3.9% to maturity, compared with 3.3% for ten-year Treasuries. Because of their tax benefits, munis have historically yielded less than Treasuries.

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If you buy individual muni bonds, stay defensive. General-obligation bonds issued by states and cities, in addition to debt that finances essential services, such as utilities and schools, should be safe. "The view from 20,000 feet is that you won't come home one day to find no electricity and no schools," says Rick Taormina, co-manager of the JPMorgan Tax Aware Real Return fund. Nearly $300 billion of the stimulus package enacted in February will flow to state and local governments, and experts believe that Uncle Sam will stop any high-profile municipal defaults. Fidelity Intermediate Municipal Income (FLTMX), a member of the Kiplinger 25, is a fine option for fund investors. It yields 3.1%, equivalent to a taxable return of 4.8% for an investor in the 35% bracket.

Opportunity abounds among high-grade corporate IOUs, but you might want to let a fund manager do the grunt work for you. Defaults and downgrades have yet to peak, so you donUt want to let a single bad choice ruin your portfolio. Loomis Sayles Bond is a good option for aggressive investors; it yields 9.0%. Risk-shy investors should consider Westcore Plus Bond (WTIBX), which holds high-quality corporate bonds, government-agency securities and a smattering of Treasuries. It yields 4.4%.

The next frog to digest may be inflation, but at least you have plenty of time to brace yourself. Slack capacity in the U.S. economy means that inflation, and an accompanying rise in interest rates, likely won't take hold at least until 2011.

But even so, you can start building a hedge against rising inflation now. High-yield corporate bonds surged in 2009 through May 8. They could be due for a pullback. But junk bonds still offer double-digit yields, and their prices are relatively independent of interest-rate movements. A good choice is T. Rowe Price High Yield (PRHYX), which yields 10.9%.

You can also hedge against inflation with bank loans, which reset their interest rates every few months in line with prevailing short-term rates. These junk-rated debts hold a senior claim on a company's assets, so bondholders get paid first in case of default. Fidelity Floating Rate High Income (FFRHX), which yields 5.3%, is a fine option.