For Bond Investors, Better Safe Than Sorry

Ever since the subprime-mortgage mess hit the fan in August, bonds have seemed less like a safe haven. Although mortgage-related troubles directly affect just a small slice of the bond market, trouble in that sector triggered a widespread selloff of virtually everything that didn't have the word Treasury in its name. As a result, ultra-safe Treasuries have soared in price (and their yields have fallen), and just about every other kind of bond has suffered.

With interest rates on long-term bonds as low as they are (the ten-year Treasury note yielded 4.2% in mid November), there's little incentive to extend maturities. And although the economy is weakening, the Federal Reserve may not have the flexibility to cut short-term interest rates any more. It doesn't want to take any steps that could accelerate the dollar's fall -- which, along with soaring oil prices, could fuel a rise in inflation.

One category that looks relatively attractive is tax-free municipal bonds. Munis aren't cheap by historical standards, but they're reasonable compared with today's elevated Treasury prices. "Because of their high-quality nature, they're a good place to hide in today's environment," says Christopher Burdick, of the Schwab Center for Financial Research.

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Munis may look even better if the Democrats sweep the 2008 elections. If that happens, higher federal income-tax rates are likely (see Whatever You Call It, It's a Mother). That would make munis' tax-exempt features much more appealing. And if Congress allows the current low tax rate on stock dividends to expire at the end of 2010, a lot of money could shift from dividend-paying stocks into munis, says Lisa More, director of Wilmington Trust Investment Management.

If you'd rather leave the bond picking to a pro, our top tax-free fund pick is Fidelity Intermediate Municipal Income (symbol FLTMX; 800-343-3548). It yields 3.6%, equivalent to 5.1% for someone in the 28% tax bracket and 5.6% for a 35%-bracket taxpayer (for more on tax-free bonds, see The ABCs of Munis).

If you want higher yields, a relatively safe choice is a bank-loan fund. These funds buy floating-rate loans made to companies with shaky credit. Although short-term rates have been falling lately -- bad news for a floating-rate fund -- they could bottom out soon. T.J. Marta, bond strategist at RBC Capital Markets, says inflation fears and a falling dollar could prompt the Federal Reserve to push up short-term rates in 2008. A good choice is Fidelity Floating Rate High Income (FFRHX; 800-343-3548). It yields 6.9%, but be aware that it lost 4% of its value in a single month last summer during the subprime-related bond-market turmoil.

The falling dollar also means that investors get a bonus from holding bonds denominated in foreign currencies. Plus, foreign bonds can lower a portfolio's overall risk. Julius Baer Total Return Bond (BJBGX; 800-387-6977) can invest up to 40% of its assets in foreign bonds and has returned an annualized 6% over the past five years.