Bond Investors Find Themselves Walking Tightrope

These are confusing times for income-oriented investors.

With the Federal Reserve Board cutting short-term interest rates, yields on Treasury bills and other short-term securities are tumbling--forcing many investors in those securities to think about alternatives.

But what the Fed’s new stance will mean for longer-term bond yields, and thus whether this is a good or bad time to lock in those yields, is still unclear.

If the Fed succeeds in staving off an economic recession, then current yields on corporate junk bonds and emerging-market debt--which have soared in recent months as investors have shunned risk--might look like great deals a few months from now.

But if the Fed is too late and investors perceive more economic trouble ahead, they could force the yields on higher-risk bonds that much higher, while driving “safe” Treasury bond yields even lower.

As with any investment decision, the income decision now depends on how much risk you’re willing to take in exchange for the yield you want, financial planners say.

The good news is that income-oriented investors who want to take advantage of higher yields on out-of-favor bonds have a lower-risk option than buying individual securities: bond mutual funds.

Bond funds spread risk over an entire portfolio of holdings--for instance, if one junk bond in a high-yield portfolio busts, its effect is offset by the majority of others that continue making payments.

“Higher-income areas, like the mortgage, high-yield and emerging-market [debt] market are typically those that require high-risk tolerance and are areas where professional management and diversification can be a great benefit,” said Alice Lowenstein, fixed-income editor for Morningstar Mutual Funds.

To be sure, individual bonds have been popular among many income-oriented investors for a variety of reasons. If individual bonds are purchased at or below par (their redemption value), they guarantee a return of principal if held to maturity. Plus, they deliver a set payout.

With a fund, there are no such guarantees. For instance, if you were to invest today in a long-term government bond fund, there’s a good chance you’d be buying into a portfolio of bonds valued well above redemption value. The manager, in an effort to seek yield or safety, might have paid $1,100 for a bond that promises to return only $1,000 once it matures.

Theoretically, this means that these bonds, once they mature, would guarantee a loss to the portfolio. In reality, though, most fund managers wouldn’t hang on to such bonds until maturity. And investors would see some compensation through the income earned.

Nevertheless, bond fund investors aren’t assured that their original principal invested won’t incur losses--especially if market interest rates should rise, depressing the value of lower-yielding bonds in a fund portfolio. (See sidebar.)

Still, the trade-off is the diffusion of risk: A bond fund portfolio can generate decent yields while protecting you against the extreme loss of principal that can occur if you own an individual bond that defaults.

Where to find those decent fund yields today? Here are some ideas:

Municipal Bond Funds

Normally, a tax-free municipal bond is considered a good deal when its yield is 85% that of Treasuries, notes Alexandra Lebenthal, president and chief executive of Lebenthal & Co. in New York, one of the leading sellers of muni bonds to retail investors.

Yet, in the last couple of months, yields on high-quality, insured, long-term municipal bonds have risen to more than 95% that of similar-maturity Treasuries.

Because income paid on munis is exempt from federal taxes, a muni yielding 4.85% is the equivalent of an 8% yield on a Treasury bond for a person in the top 39.6% federal income tax bracket.

But Duke Johnson, president of the La Jolla Institute for Wealth Management in La Jolla, stresses the need to find good-quality, low-cost muni funds.

For California investors, he recommends the Vanguard California Tax-Free Intermediate-Term bond fund (no-load; minimum initial investment: $3,000).

The average credit quality of bonds in this $895-million portfolio is AAA, the highest possible. And the average annual expenses for this fund are a low 0.18% of assets. That’s 83% less than that of the typical muni bond fund. Plus, because this fund invests only in bonds issued by California municipalities, income derived from it is exempt from both federal and state taxes.

With a 4.46% 12-month yield, that’s the equivalent of an 8.7% yield on a Treasury for state residents in the combined 48.9% state and federal tax bracket.

Johnson also likes USAA California Bond Fund (no-load; minimum initial investment: $3,000).

This $533-million single-state fund has recently yielded slightly more than Vanguard’s fund--about 5.2%. The tax-equivalent yield would be about 10.1% for someone in the 48.9% state and federal tax brackets.

To be sure, fund manager Robert Pariseau achieves this yield by taking on more risk. In the past, Pariseau took on more “interest rate risk” by investing in longer-term munis. Recently, he has reduced that stake and has instead invested in lower-quality bonds.

But he doesn’t go overboard. The average credit rating of the portfolio is still a respectable AA.

For those willing to venture out of California--and therefore willing to trade the state tax break for greater diversification among muni bonds--Johnson recommends Sit Tax-Free Income (no-load; minimum initial investment: $2,000) with a 12-month yield of 5%.

Investment-Grade Corporate Bond Funds

Yields on high-quality corporate debt range from 5.7% to 6.6% today--well above Treasury yields.

Here, Morningstar’s Lowenstein recommends three steady eddies: T. Rowe Price Corporate Income (no-load; minimum initial investment: $2,500), sporting a 7.7% 12-month yield; Bond Fund of America (4.75% load; minimum initial investment: $1,000), yielding 7.1%; and SteinRoe Income (no-load; minimum initial investment: $2,500), with a 6.9% yield.

Each of the funds maintains decent yields by investing a minority of their holdings in junk bonds, while keeping the bulk of the portfolio in high-quality bonds.

Among the three, T. Rowe Price Corporate Income, which invests about 30% of its assets in lower-quality debt and offers the highest yield, is considered the riskiest by Morningstar. Bond Fund of America, which hedges its 25% stake in junk bonds with its 30% stake in U.S. government debt, is considered the safest.

High-Yield ‘Junk’ Corporate Bond Funds

Income investors searching for opportunities in the high-yield junk sector must do so with extreme caution, said Ridgewood, N.J., financial planner Paul Westbrook.

While the typical junk bond fund yields 9.2%--that’s 82% more than the typical U.S. Treasury bond fund--it’s uncertain how well that income, or one’s principal, will be protected.

In coming weeks, for example, Wall Street will be paying close attention to how investors interpret the Fed’s recent interest rate cuts: whether recession will be held off, or whether it’s unavoidable.

Investors have pushed junk bond values lower, and yields higher, because of recession risk. According to Morningstar, the typical high-yield fund lost 2.1% in total return during the last 12 months.

But if recession fears recede, junk bond values could jump, pushing yields down again.

If those fears worsen, yields could rocket higher.

To be on the safer side, Morningstar’s Lowenstein favors high-yield funds that protect principal by avoiding large pockets of danger.

Two such funds are Northeast Investors (no-load; minimum initial investment: $1,000) and Invesco High-Yield (no-load; minimum initial investment: $1,000).

While most of its peers have been buying up junk bonds in the booming telecommunications sector, Northeast Investors has largely avoided this sector. Ernest and Bruce Monrad, who co-manage this $2.6-billion fund, believe that the high debt levels and poor cash flows of some companies in the industry represent too much risk for the portfolio.

Because of this cautious approach, Northeast Investors has finished among the top half of its peers in terms of total returns in nine of the last 11 years. Yet the fund still is yielding 9.2%.

Unlike Northeast Investors, Invesco High-Yield has ventured into the telecom sector. And about three-quarters of the fund’s holdings are rated B or less--putting it toward the lower end of the junk bond spectrum. But Jerry Paul, who manages this $681-million fund, has largely avoided foreign bonds, unlike many of his peers.

That has helped protect total returns while generating annual yields of 9% or more for more than a decade.

Emerging-Market Debt Funds

Developing-country debt funds dangle a big carrot in front of income investors--average yields of 13.7%. Unfortunately, they threaten to hit them over the head with an even bigger stick: The typical emerging-market debt fund has lost nearly 37% during the last 12 months as bond values have crashed.

Many fixed-income analysts believe the sector is still filled with too many land mines for individual investors to navigate--whether it comes to Latin American, Russian, or Asian bonds.

That’s why Michael Chasnoff, president of Advanced Capital Strategies in Cincinnati, suggests investors play this sector by investing in multi-sector or general corporate bond funds that use a small amount of emerging-market debt to boost yields. For the most conservative investors, he recommends Pimco Total Return (4.5% load for A shares; minimum initial investment: $250).

Managed by the legendary William Gross, this $18.5-billion fund invests in high-quality corporate and government debt, but spices up that mix by adding a smidgen of junk and emerging-market bonds.

This approach has provided an 8.9% total return year-to-date, with a 5.2% 12-month yield.

“Bill Gross is not going to make more than a small wager into the international and emerging-market debt sectors,” said Chasnoff.

For more aggressive investors, Chasnoff recommends Fidelity Adviser Strategic Income Fund (no-load for B shares; minimum initial investment: $2,500), which sports a 12-month yield of 6.4%.

This fund invests a slightly greater portion of its assets in junk and emerging-market bonds.

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In Search of Yield

Here are 10 bond mutual fund ideas for investors looking for decent yields. Not surprisingly, the two highest-yielding funds--Invesco High-Yield and Northeast Investors--are junk bond funds that expose investors to greater risk (note their negative year-to-date “total return,” which is yield plus or minus principal change). At the bottom are three municipal bond funds, whose yields are understated because they are tax-exempt. The list shows two yield figures for each fund: The 30-day yield takes a snapshot of a fund’s payout rate over the past month, while the 12-month yield is based on income distributed to investors over the last year.

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YTD 3-year 12-mo. 30-day Fund name tot. ret. tot. ret. tot. ret. yield Invesco High-Yield -7.2% 8.9% 9.2% 10.5% Northeast Investors -7.9 8.3 9.2 10.1 T. Rowe Price Corp. Inc. -3.0 NA 7.7 7.6 Stein Roe Income 1.4 6.4 6.9 6.9 Bond Fund of America 1.4 7.0 7.1 6.6 Fidelity Adv. Strategic Inc. -3.0 6.9 6.4 6.6 Pimco Total Return 8.6 NA 5.2 6.0 Sit Tax-Free Income 5.5 7.9 5.0 4.5 USAA California Bond Fund 6.6 8.9 5.2 4.1 Vanguard Calif. Tax-Free Int. 6.1 7.0 4.5 3.8

800 Fund name number Invesco High-Yield 525-8085 Northeast Investors 225-6704 T. Rowe Price Corp. Inc. 638-5660 Stein Roe Income 338-2550 Bond Fund of America 421-4120 Fidelity Adv. Strategic Inc. 522-7297 Pimco Total Return 927-4648 Sit Tax-Free Income 332-5580 USAA California Bond Fund 382-8722 Vanguard Calif. Tax-Free Int. 662-7447

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Total return and 30-day yield figures are through Oct. 16.

Twelve-month yield figures are through Sept. 30.

Source: Morningstar