With Rate Hike, Is It Time to Bail Out of Bonds?

Rapidly rising interest rates have savaged bond investors, who lost an average of 17.5% of their principal over the 12 months ended Oct. 31.

With the Federal Reserve Board raising rates another three-quarters of a percentage point last Tuesday--further threatening some bond funds and individual bond values--many are beginning to ask if it’s time to bail out.

“If I could get the courage to take the losses I have, I’d like to go into certificates of deposit or short-term Treasuries,” says Barbara Healy, a Los Angeles retiree. “But I just don’t want to take the losses.”

Is it time to sell?

The answer depends on who you are and why you are in the market. If preservation of capital is your main goal and market gyrations make you nervous, cash is king, says David H. Glen, managing director at Scudder Stevens & Clark in Boston. Get out of bonds and put your money in bank deposits and Treasury bills, he says.

But if you’re an income-oriented investor who isn’t undone by volatility, this may be an ideal time to buy. Indeed, Glen and other bond experts maintain that the recent market slaughter has created the most attractive opportunities for new bond investors in years.

Better yet, today’s opportunities are often in fairly short-term and very safe securities. That’s in stark contrast to the bond market hot spots of just a few years ago, when the greatest values were in low-quality, high-yield bonds and international bonds that exposed investors to both interest rate and currency risks.

“There has been a real bloodletting in the market over the past 12 months,” says James J. Cooner, senior vice president at Bank of New York. “But to just say ‘A pox on bonds’ would be a big mistake.”

It’s a classic case of “bad news is good news,” experts maintain. The reason is simple: Most investors buy bonds because they’re looking for income. And in today’s market, bonds are paying more to investors than at any time in the past three years. In addition, although it was hard to imagine interest rates falling from where they were a year ago, rates are now at levels that could ease if the economy slows in coming months. If interest rates fall in the future, bond investors will see their principal values rise. So new investors could reap the best of all possible worlds.

“The consensus view is that the worst part of the bond market decline is behind us,” adds Robert A. Berliner, chairman of Westmount Asset Management in Century City. No one rings a bell to signal a market nadir, Berliner adds. “But if we’re not at it, we’re approaching it.”

Many experts believe that today’s best options are in Treasury bills and notes with maturities of between one and six years and in municipal securities. For individuals in high tax brackets, municipals are particularly hot, providing double-digit after-tax yields, Cooner says.

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Consider, for example, the state of California’s recent offering of 12- and 15-year zero coupon bonds.

These bonds, many of which were privately insured to produce a credit rating of AAA, sold at yields ranging between 6.25% and 6.55%, says Zane Mann, editor of the California Municipal Bond Advisor in Palm Springs. For a middle-income taxpayer whose combined federal and state tax bracket is about 37%, that translates to taxable equivalent yields ranging between 9.57% and 10.03%, he says. (The taxable equivalent yield is the amount you’d have to earn on a taxable investment to take home the 6.25% or 6.55% you’d earn on the municipal bond, which is federal and state tax-free.)

Treasuries are also looking like bargains, Cooner says. A simple two-year note is now paying a bit more than 7%. You pay federal tax on Treasury security earnings, but the income is free of state taxes.

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Yet concerns about market volatility have some investors shying away from bond mutual funds and opting to buy individual bonds instead. Investors have control over whether an individual bond is sold, since a mutual fund has to sell bonds when customers are cashing in, whether it is a good time to sell or not.

Another reason for this shift is psychological, Glen says. People don’t like to think about their losses, and mutual funds force you to recognize that you have them because fund net asset values are published in the paper each day. If, instead, you buy Treasuries directly from the Federal Reserve System and hold them to maturity, you get the promised interest, your principal at maturity and nobody tells you if the bond’s value fluctuates in the interim.

However, in a bond fund, you generally have much greater access to your cash. Not only is it easy to sell, you can sell just a portion of your holdings--without paying a commission, assuming you’re dealing with a no-load fund. If you buy individual bonds, selling requires a broker and a minimum commission.

In addition, bond funds constantly reinvest their cash, which allows them to boost yields paid to investors as interest rates are rising. With an individual bond, you get the rate you contracted for, no matter what happens to interest rates in the interim. This can be an advantage as well, of course, when interest rates are dropping.

However, whereas government-issued bonds are looking good, the picture at the riskier end of the bond market is nowhere near as bright.

International bonds, which were touted a few years back as great alternatives to low-yielding U.S. debt, have taken a hit because interest rates have fallen steeply in many other countries too. Looking forward, investment professionals worry that currency swings could slam U.S. investors who buy overseas bonds for the simple reason that the dollar is at an all-time low against virtually every major currency. If the dollar gains ground, foreign bonds and bond funds get hit.

So-called junk bonds are also not recommended, says Ronald Vannuki, managing partner at Santa Monica-based Drake Capital and a junk bond specialist. When interest rates were falling, junk bond issuers were refinancing their debts. And because the economy was on the mend, the companies were getting healthier.

Today, yields on junk bonds are not significantly higher than what the Treasury is paying on its debt. And if the Federal Reserve is successful in slowing the economy--the point of all these interest rate increases--junk bond issuers may find it harder to keep their companies healthy and, just as important, paying their debts on time.

“Right now, you’re just not getting paid enough to go into lower-quality bonds,” Vannuki says.

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* Reprints of “Live Well, Die Prepared,” Kathy Kristof’s advice on will preparation, avoiding probate and cutting the cost of medical treatments and funerals, is available from Times on Demand. Call 808-8463, press *8630, and select Option 3, Item 8523. Cost is $5.41 plus 50 cents postage. Available by mail only.