Market Watch : Getting More Yield From Your Bond Funds

Get out the exercise mat and sweat clothes: It’s time to stretch for yield.

With conservative investments now paying some of the slimmest interest rates in memory, a lot of people are warming up to the idea of making some changes in their portfolios. Quite a few have taken those first, tentative steps already.

Just keep in mind that the pursuit of higher gains usually requires some pain--in the form of added risk. Assuming you want to pump up your returns while sticking mostly with bond funds, here are the approaches you will need to consider:

* Accept lower quality.

One way to reap higher income is to move into mutual funds holding more speculative bonds. Risk pays--at least in theory--so if you switch into more speculative investments, you can generally look forward to better potential returns.

In terms of credit or default risk, Treasuries and other government bonds are considered to be safest, while high-yield or junk debt rates are the most speculative. International bonds and bond funds would also fall into the riskier category because of the dangers posed by currency fluctuations.

At the moment, some pros are recommending high-yield funds, since an improving economy suggests that the funds will be saddled with fewer defaulting bonds.

“Personally, I think the risks in the junk market are overblown and will become less apparent as the economy moves forward,” says Ralph Norton, managing editor of the Bond Fund Report in Ashland, Mass.

In the meantime, investors are being compensated for accepting the increased volatility, he says.

The average junk fund tracked by his newsletter yields 9.4%, well above the 6.2% for high-quality corporate funds and 6% for long-term government portfolios. All figures are SEC-standardized 30-day yields.

Norton suggests that moderately risk-tolerant income investors might consider junk funds for up to 30% of their bond holdings. His favorites include Vanguard Fixed-Income High-Yield Corporate (800-662-7447), T. Rowe Price High Yield (800-638-5660) and Fidelity Capital & Income (800-544-8888).

Patricia Raskob of Raskob Kambourian Financial Advisers in Tucson also recommends junk funds for some clients, but no more than 10% or so of an individual’s overall holdings. In addition to the Vanguard portfolio, she likes Financial Bond High Yield (800-525-8085).

* Lengthen maturities.

Another way to stretch for income is to move into funds holding longer-term bonds. For example, you might go from a government fund with two- or three-year bonds to one whose holdings come due in 10 years or more.

Assuming interest rates stay flat or drop, longer-term funds will generate a higher income and possibly appreciate. But if rates rise, their heftier dividends will be partly offset by capital losses.

As a compromise, you might consider a laddering strategy. This involves putting equal amounts into short-, intermediate- and long-term funds. The idea is to earn more than a money market or short-term fund only, while assuming less risk than with a long-term portfolio.

“This would cover the bases and give you a blending of rates,” says Norton.

You can also generate similar results by simply sticking with an intermediate-term portfolio.

Carl J. Camp, president of Eclectic Associates in Fullerton, suggests using intermediate funds without any long-term portfolios. “The risk-reward trade-off with long-term bonds isn’t that great, especially given today’s generally low rates,” he says.

Among government bonds, for instance, the intermediate funds are yielding about 5.6% on average, according to the Bond Fund Report, not much worse than the 6% rates paid by their long-term siblings.

* Consider tax-exempt income.

Since a dollar untaxed is worth more than a dollar taxed, municipal bond funds can be good vehicles to earn higher effective yields, even though their nominal rates fall short of what’s paid on corporate and government debt.

Long-term muni funds are yielding about 5.4% now, according to the Bond Fund Report. That equates to 7.5% worth of taxable income for someone in the 28% bracket.

“The municipal sector is a very good place to be right now,” Norton says, adding that the bonds could become even more attractive if President Clinton raises taxes.

“Anyone in the 28% bracket or higher should be looking at the muni sector first.”

Norton’s favorites here include Dreyfus Municipal Bond (800-645-6561), Fidelity Limited- Term Municipals (800-544-8888) and Vanguard’s Municipal Intermediate-Term portfolio (800-662-7447).

* Consider equity kickers.

So much for the main ways to enhance returns on a pure-bond portfolio. If you seek still higher performance, you will probably have to put some cash into the stock market.

One advantage of stocks from an income perspective is that their dividends can be expected to grow over time. Interest payments on a bond, by contrast, stay at a fixed level.

Income mutual funds, which typically hold about 60% bonds and 40% stocks, are a good way for conservative investors to take that first step into the equity arena, with at least part of their money.

One of Camp’s income favorites, Lindner Dividend (314-727-5305), has been yielding about 7% recently on a portfolio of stocks, bonds and convertibles.

Raskob also likes Lindner Dividend, along with Vanguard Wellesley Income (800-662-7447).

Remember, though, that income funds are roughly in the same league as junk-bond portfolios in terms of risk.

“Whenever you bring equities into the picture, that increases the price variability,” says Norton.

How Risky Are Your Bond Holdings?

With interest rates at a fairly low point in the long-term cycle, it’s worth reviewing the impact that rate fluctuations exert on bond prices. In short, prices move in the opposite direction from rates, and long-term bonds feel the impact more than short-term securities do.

This chart shows what would likely happen to various categories of Treasuries if interest rates rose or fell by one percentage point. The yardstick can also be applied to bond mutual funds if you know the average maturity of the portfolio holdings.

Price change Price change Maturity if rates rise if rates fall in years one point one point 1 year -0.94% +0.95% 3 years -2.58% +2.66% 5 years -3.96% +4.16% 10 years -6.50% +7.11% 20 years -9.20% +10.68% 30 years -10.32% +12.47%

Source: Albert J. Fredman, finance professor, California State University, Fullerton.