Investors Say Bully for Bonds : Opportunities Abound for Those Burned by Stocks

Out of disaster often comes opportunity.

Such is the case with Treasury securities, municipal bonds, corporate bonds and other types of bonds. Before the recent stock market crash, many investment advisers were bearish about bonds, afraid that higher interest rates and rising inflation would erode their value.

But in the first few days after the stock market carnage, bonds arose with new-found luster. Large institutional investors, seeking a safer haven than stocks in a classic “flight to quality,” poured billions of dollars into bonds, particularly short-term Treasury securities.

However, just like the stock market, the bond market is undergoing a period of high uncertainty and volatility. It is the result of a murky outlook on interest rates, the dollar and the U.S. trade and budget deficits. In the past few days, new worries about a falling dollar--which drives down the value of U.S. bonds to foreign investors--have prompted some experts to worry that both bonds and stocks could be in a prolonged bear market.

So is now a good time to buy bonds or bond mutual funds?

Yes, particularly if you want a steady source of income or if you are convinced that interest rates are headed down, advisers say. But just as in picking stocks, small investors should exercise extreme caution in choosing the right bonds and bond mutual funds. While some are quite safe and stable, others are risky and volatile, rising and falling in price nearly as much as stocks.

The prices of some types of bonds and bond funds are so volatile “that you could lose all your gains in a single day,” said William E. Donoghue, editor of Donoghue’s Moneyletter, a newsletter based in Holliston, Mass. Some bonds “are simply a speculative vehicle that people should not invest in for income, particularly in these uncertain, volatile markets.”

Also, a recession--which many economists forecast for next year--could boost defaults on interest payments of some corporate bonds, particularly so-called high-yield “junk” bonds. A recession also could increase risks of default for some tax-exempt municipal bonds as well.

The following questions and answers could help you determine whether, and what type of, bonds are for you:

Q: What is a bond?

A: When you buy a bond, you are in effect lending your money to the bond’s issuer--usually a corporation or government entity--in exchange for payments of interest. The bond obligates the issuer to make those payments, usually at specified intervals, and to repay the face value, or principal, of the bond at maturity.

Bonds are used by corporations and government entities to finance a wide variety of activities, ranging from factory construction to takeovers of other companies.

Bonds, however, do not entitle the investor to a say in the affairs of the issuer. Stocks, on the other hand, are a form of ownership of a company and give holders a right to vote on certain corporate matters. They also represent a claim on the company’s earnings and assets, in many cases paying income to investors through dividends.

Investors can buy both stocks and bonds when they are newly issued. But investors who want to buy or sell already issued bonds can do so through brokers or, in the case of some bonds, through the issuer. To facilitate the buying and selling of already issued stocks and bonds, they are traded on exchanges and other types of markets, and their prices rise and fall according to economic conditions and investor demand.

Q: How do bonds compare with stocks?

A: Bonds traditionally have been thought of as steady, long-term investments that investors buy and hold to earn a stable rate of return. Stocks, on the other hand, have been considered more risky because of their volatility.

But that view is changing. First, studies show that over the past 60 years or so, stocks on average have outperformed bonds. One such study, by researchers Roger G. Ibbotson and Rex A. Sinquefield, shows that, since 1926, stocks have earned an average 9.3% rate of return versus only 3.6% for long-term government bonds and 3.3% for Treasury bills.

Second, the nature of bond investing for the small investor has changed radically. Years ago, most small investors in bonds bought individual issues, collecting interest and holding them until maturity.

But today, most small investors buy bonds through bond mutual funds. Funds are available that invest in nearly every type of bond with different maturities. For the same amount of money, they give investors far more diversification than buying individual issues. But the interest income and value of fund shares fluctuate on a daily basis, because bond funds never mature like individual bonds and because bond funds constantly buy and sell to reflect changing market conditions. That makes bond funds a shorter-term investment than individual bonds.

Unit investment trusts are a more stable alternative to bond mutual funds. They are set up by brokerages or investment companies and hold a fixed, unchanged portfolio of securities. That stabilizes the yield for the investor, who buys shares of the trust.

Q: Why is the outlook for bonds so murky?

A: The benefit of buying bonds now will depend largely on where interest rates throughout the economy are headed. If you think rates are going down, bonds will be a good buy.

Unfortunately, no one is sure of the direction of interest rates. Although interest rates have declined since the stock crash, economists can’t agree on whether that fall will continue, says Robert J. Eggert, editor of Blue Chip Economic Indicators, a Sedona, Ariz., newsletter that polls economists.

The problems of the economy have put conflicting pressures on the Federal Reserve Board, making it extremely difficult to forecast interest rates.

Experts predicting lower interest rates argue that recent steps by the Fed to pump money into the economy to quell the stock crisis will push interest rates lower. Also, they argue, the stock market plunge will hurt consumer spending, increasing prospects for a recession. A recession, by slowing demand for credit, will help lower interest rates.

“Growth will be weaker, inflation will be lower, and interest rates will decline further,” declared widely followed Salomon Bros. chief economist Henry Kaufman in a recent report that was bullish on bond prices.

However, others worry that the Fed eventually may be forced to raise interest rates to prevent further declines in the dollar. A weaker dollar makes Treasury bonds and notes, which are denominated in the U.S. currency, less attractive to Japanese and other foreign investors. But foreign investment in Treasury securities is needed to finance the bulging U.S. budget deficit. Thus, to make those foreign investors happy, the Fed may need to force interest rates higher, some experts say.

“The prospect of a falling dollar could be the biggest negative for bonds,” said William H. Gross, managing director of Pacific Investment Management Co., a Newport Beach firm that manages fixed-income portfolios for pension funds.

Q: With such an unclear outlook, what should I do?

A: If you are conservative, one thing you can do is buy bonds with shorter maturities. Their prices won’t be affected as much by changing interest rates.

Q: But aren’t higher interest rates good for bonds?

A: Not really. Sure, higher rates mean you can get a higher yield when you buy a bond (which is why the Fed may force rates higher to make Treasury securities attractive to foreign investors). They also mean a higher initial yield if you buy a share in a bond mutual fund.

But if interest rates continue to go higher after you buy, the value of your bond or bond fund will fall. That is because investors won’t pay full price for your bond if they can buy a new one at the same price with a higher yield. The price of your bond must fall to compensate for the fact that its yield is lower than yields on comparable new bonds.

Plunging prices of bellwether 30-year Treasury bonds earlier this year illustrate this risk. These issues plummeted more than 20% between March and September, thanks to sharply higher interest rates. Such a decline more than offset the yield on the bonds.

So as a rule, bond prices move in opposite directions from interest rates in the economy. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. That is why falling interest rates generally are regarded as bullish for bonds, while higher rates are bearish.

Also, bond prices rise when demand for bonds grows.

Q: How can you be sure of getting your principal back?

A: Hope that interest rates decline, so that your bond will be worth more. Or hold the bond until it matures, when you should get back the full face value of the bond.

Q: What is the benefit of holding a bond until maturity?

For most types of bonds, holding until maturity will ensure that you get back the full face value of the bond. The interest payments, however, remain constant on most types of bonds, regardless of how long you hold them.

Q: Who, then, should buy bonds?

A: Prudent investors should have bonds or bond funds as part of a diversified portfolio that also includes savings accounts and possibly stocks, real estate and precious metals, most experts say. What kind of bonds or bond funds are right for you depends on how much risk you are willing to take.

As a general rule, lower-quality bonds pay higher yields. Bonds with longer maturities also pay higher yields.

If you are conservative, cannot afford to lose your initial investment and are primarily interested in interest income, stick to high-quality, shorter-maturity bonds or bond funds.

On the other hand, if you are more willing to gamble--and you think interest rates are headed lower--then consider longer-maturity, higher-yielding bonds.

Q: Which bonds are the safest from default?

A: The safest bonds are those issued by the U.S. government or its agencies. They include Treasury bills, notes and bonds; Ginnie Mae securities and U.S. savings bonds. Uncle Sam guarantees interest payments and full return of principal when the bonds mature.

Tax-exempt municipals also are considered safe, but not as safe as Treasuries. They are backed by issuing municipalities but could default if the projects supported by bond revenues go sour.

Corporate bonds vary widely in safety. The highest-rated bonds, given AAA or AA ratings because they are issued by the financially strongest corporations, carry only a slight risk of default. Low-rated, high-yielding “junk” bonds carry a higher risk of default, particularly if a recession hurts the financial health of the issuer.

Q: Which bonds or bond funds are the safest for conservative investors who don’t want any risk of loss of principal?

A: Among the safest are money-market mutual funds, which invest in Treasury bills, short-term corporate debt, bank certificates of deposit and other short-term credit instruments. They currently yield an average of 6.53%, according to Donoghue’s Money Fund Report, and have virtually no risk that you will lose your initial investment.

Additional safety is available through money-market funds that invest exclusively in U.S. government securities. Their latest average yield is 6.03%, according to Donoghue’s Money Fund Report.

Three-month, six-month and one-year Treasury bills also are conservative. Three-month bills yielded 5.02% as of Thursday while six-month bills earned 5.78% and one-year bills yielded 6.23%.

Also considered relatively secure are corporate bonds with top AAA or AA ratings and maturities of 10 years or less. They are yielding on average about 9.65%. However, corporate bonds carry the risk of being “called”--that is, redeemed by the issuer before maturity. That would happen if interest rates drop sufficiently low, because then the issuer will want to refinance the bonds at lower rates. Such call provisions deprive investors of part of their opportunity for capital gains when interest rates tumble.

Tax-exempt municipal bonds are considered prudent for investors in higher tax brackets. They are exempt from federal tax. And for investors living in the state of a bond’s issuer, they are exempt from state tax as well.

The most conservative way to invest in tax exempts is through tax-exempt money funds. They currently yield an average of 4.44%, according to Donoghue’s Money Fund Report. For an investor in this year’s top 38.5% tax bracket, that 4.44% tax-exempt yield is equivalent to a yield of 7.22% on a comparable taxable money-market fund. Since the average yield on taxable money-market funds is currently only 6.53%, investors in the top bracket would earn more in a tax-exempt money-market fund.

New AA-rated tax-exempts with maturities of one to 10 years yield an average of about 7.5%. That’s equivalent to a yield of 12.2% for a comparable taxable bond, if you’re in the top 38.5% tax bracket.

Another choice for conservative investors is Series EE U.S. savings bonds. Uncle Sam guarantees interest and principal. If you hold them for at least five years, you are guaranteed to earn at least 6% annually. Those buying them Monday should earn a rate for the first six months of at least 7%. A major drawback: If you need to sell them back before five years, you will earn less than 6%.

Another possibility are Ginnie Mae certificates. They are issued by the Government National Mortgage Assn., a quasi-government agency, and are backed by mortgages the agency holds. The certificates in effect “pass through” the monthly mortgage interest and principal payments from homeowners. Ginnie Maes currently yield about 10.5%.

However, while interest and principal payments are backed by the government, you never can be sure how big they will be or how long you will get them. For example, if interest rates decline, homeowners will likely refinance the mortgages in the Ginnie Maes. That forces the agency to return part of the principal back to you, in effect shortening the maturity. And you will have to reinvest the principal in new investments that may yield less.

Small investors are better off with Ginnie Mae mutual funds. First, Ginnie Mae certificates cost at least $25,000, while Ginnie Mae mutual funds require initial investments of as little as $1,000. Second, mutual funds will automatically reinvest the principal, saving you the trouble.

Q: Which bonds are best for aggressive investors seeking higher yields and willing to bet on falling interest rates?

A: The highest-yielding bonds are junk bonds. They are issued by corporations and carry lower ratings than other corporate bonds because issuers are relatively new or small or in somewhat shaky financial condition. Some junk bonds also are issued to finance corporate takeovers.

Junk bond advocates argue that their higher yields more than compensate for the added risk. Junk bonds currently yield on average about 13.5% but are highly volatile in price. Because of their default risk and volatility, the best way for small investors to play the junk bond game is through high-yield-bond mutual funds. The diversification you get will protect you if some of the issues default.

Aggressive investors also might consider longer-term top-rated corporate bonds with maturities of 10 years or more. They currently yield on average about 10.4%, but with some price volatility.

Another somewhat speculative vehicle is convertible bonds. They are part stock and part bond in that they pay bond-type interest but also can be profitably converted into the issuing company’s stock if the the stock price rises a certain amount. However, they do not yield as much as ordinary corporate bonds and fluctuate in price along with the price of the issuer’s stock.

Among the most volatile bond investments are long-term zero-coupon Treasury bonds. Zeroes, as these issues are often called, pay all their accumulated interest at maturity instead of at regular intervals. That makes their prices particularly sensitive to slight changes in interest rates. A 30-year Treasury zero, for example, will rise or fall 30% in price for only a one percentage point change in interest rates, Newport Beach bond adviser Gross said.

Illustrative of that volatility is the recent performance of a mutual fund that invests in long-term Treasury zeroes, Benham Target 2015. It was up 22% last week but down 20% the week before, newsletter editor Donoghue said. The message for conservative investors: avoid these funds. So if you are conservative, buy individual zeroes with the intent of holding them until maturity so you don’t have to worry about their wild price fluctuations.

Q: Do other bonds also have wild swings in price?

A: A 30-year Treasury bond will fall 10% in price for each percentage point rise in interest rates in the economy, and vice versa, Gross said. Ten-year Treasuries will rise or fall 6% in price for each percentage point change in interest rates, while five-year Treasuries will move 4% and two-year Treasuries will adjust 2%.

Higher-rated corporates are somewhat less volatile than Treasuries, partly because of their call provisions. Thirty-year corporate bonds rated AAA or AA will move 7% in price with a one percentage point change in interest rates, while 10-year corporates will move between 4% and 5% and two-year corporates will adjust 2%, Gross said.

Thirty-year Ginnie Maes move 6% in value for each percentage point change in interest rates, while 15-year Ginnie Maes go up or down 5%, Gross said.

Q: What are the best ways to buy bonds?

A: You can buy individual corporate and municipal bonds from brokers, who will charge commissions that vary depending on the issue. Treasuries can be bought from Federal Reserve banks and branches.

Unit investment trusts and mutual funds can be bought from brokers. However, if you are willing to do your own research, you can save the commission charge, or “load,” by buying no-load mutual funds directly from fund companies. Call the fund company for a prospectus and application, and send your money with the application. Most funds have toll-free numbers.

Many advisers recommend that small investors diversify further by investing in several different types of bond funds, with different maturities.