If Bond Isn’t Your Word . . .

The stock market’s dazzling performance, particularly lately, has convinced most investors that equities are worth owning. But the same can’t be said of bonds.

Their yields have been lackluster in recent years. So have their total returns, which take price movements into account. Moreover, largely because some investors define the bond market as just Treasuries, there is a perception that bonds are simply too dull.

Still, virtually every seasoned financial advisor suggests that investors--no matter how young or old--should have bonds in their portfolios. But a market that includes the likes of corporate junk bonds, Third World bonds and exotic derivative issues is anything but dull. In fact, certain segments are far too volatile for investors who can’t tolerate a lot of risk.

Although bonds generally return less and pose less risk than stocks, that’s not always true. The last time the stock market went through a down period, in the 1970s, the return on two-year Treasury notes--one of the dullest fixed-income investments--handily outpaced that of stocks for a full decade. In 1982, when interest rates were finally beginning to drop after hitting historic highs, the Standard & Poor’s 500-stock index posted a healthy 21.6% return. But the return on 30-year Treasury bonds was far better: 43.6%, thanks to falling interest rates that sharply boosted the price of those bonds, says Joan Payden, chief executive of Payden & Rygel, a Los Angeles-based money management firm.

“We are always tainted by what happened last,” Payden says. “But at some point in time, bonds will do better than stocks.”

In addition, returns on stocks and bonds can and frequently do move in the same direction at the same time, but rarely do they move at the same pace. Sometimes returns on stocks and bonds move in opposite directions, which makes them a ideal duo for diversification, smoothing the bumps in your investment portfolio.

How do the risks and rewards of bonds compare with stocks?

When you invest in bonds, you are in effect lending the issuer money. In return, the issuer promises to pay back your principal at some time in the future and to pay a set rate of interest for as long as the bond is outstanding. Consequently, you face two risks--of default and of interest rate fluctuations.

Default risk is the chance that the issuer--be it a government or a corporation--will get into financial hot water and be unable to pay all or part of the principal or interest. The amount of default risk varies dramatically by the type of security.

Treasury notes and bonds are believed to be virtually free of default risk because the U.S. government is highly credit-worthy. The default risk on debt issued by highly indebted companies or Third World countries, on the other hand, is fairly substantial.

Because risk and reward go handin hand, an investor who can handle uncertainty can usually boost the yield on a bond portfolio by investing a portion of it in securities that pose some default risk. Generally speaking, junk bonds--that is, below-investment-grade securities, often issued by heavily indebted corporations--and bonds issued by Third World countries pay between 3 and 10 percentage points more than debt issued by the Treasury. Interest rate risk crops up when inflation and interest rates are rising. A long-term bond bought when interest rates were higher yields much more than a bond bought today, and one bought in a time of lower interest rates now yields much less. Thus, the price on that higher-yielding bond will rise and the price on the lower-yielding bond will drop. How much it will drop depends on the bond’s maturity--the amount of time the issuer has before it must pay the principal back--and the difference between going market interest rates and the return on the bond. According to an analysis by Oppenheimer Funds, a New York-based mutual fund company, the estimated value of a 2 1/2-year Treasury note will decrease by about 2% if interest rates rise 1 percentage point, but the value of a bond that matures in 20 years will decline by about 8%.

If you invest in bond mutual funds, which post their net asset values each day, you will see the effect of rising interest rates on your funds immediately. However, if you invest in individual bonds, you may not notice. That’s simply because no one “marks their bonds to market”--that is, no one tells you the price you’d get if you were selling the bond today.

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But what types of bonds should you buy?

The answer depends on you. If you are in a high tax bracket, consider municipal bonds, because the interest is free from federal and state income taxes. To know whether municipals are a good deal for you, compare what the total return on a municipal would be to a return on a taxable bond. To do that, calculate the “taxable equivalent” yield. That allows you to make apples-to-apples comparisons between investment returns that won’t be taxed and those that will. (See the work sheet on this page.)

If you’re an investor who can handle a higher default risk, boost your returns by buying comparatively riskier securities. If you’re looking for lower risk, on the other hand, buy high-quality bonds, such as U.S. Treasuries, with short maturities--those that will pay back the principal in five years or less.

In many cases, investors would be wise to diversify their bond portfolios just as they are to diversify their stock holdings, says Peter Van Dyke, managing director and head of the taxable fixed-income department at T. Rowe Price Associates, a mutual fund company.

For example, if you have a substantial bond portfolio, put a portion in junk or international bonds, a portion in Treasuries and perhaps a portion in municipal bonds or mortgage-backed securities. The Treasury portion will keep a bit of your principal safe while the junk portion will boost the return. The municipal portion can lower your tax obligation, and the mortgage-backed security portion lends another element of diversity.

However, such diversification may be impractical if you have a small amount to invest, because individual bonds are normally sold in $1,000 multiples. In that case, a mutual fund makes more sense.

How do you choose the right mutual fund? That’s our next lesson.

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Want more information on bonds?

Fidelity Investments mutual fund company, (800) 544-8888, has a free 40-page booklet, “Discovering Opportunities With Fixed Income Investments.” The U.S. government puts out a booklet called “Buying Treasury Securities.” Write: Consumer Information Center, P.O. Box 100, Pueblo, CO 81009, or download it via the center’s World Wide Web site, https://www. pueblo.gsa.gov

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Which Bond Is Right for You?

Taxable or nontaxable? When investing in bonds, that is a key question.

To answer it, figure your marginal tax bracket for both state and federal taxes, and then compare the yields on taxable investments to the “taxable equivalent” yield on tax-free bonds.

Here’s a step-by-step guide:

1. Determine your marginal federal income tax bracket*:

Single, with taxable income of:

up to $20,050: 15%

$20,051 to $48,450: 28%

$48,451 to $73,850: 31%

$73,851 to $131,875: 36%

$131,876 and up: 39.6%

Married, filing jointly, with taxable income:

up to $40,100: 15%

$40,101 to $96,900: 28%

$96,901 to $147,700: 31%

$147,701 to $263,750: 36%

$263,751 and up: 39.6%

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2. Determine your marginal state income tax bracket*:

Single, with taxable income of:

up to $4,908: 1%

$4,909 to $11,632: 2%

$11,633 to $18,357:4%

$18,358 to $25,484: 6%

$25,485 to $32,207: 8%

$32,208 and up: 9.3%

Married, filing jointly, with taxable income of:

up to $9,816: 1%

$9,817 to $23,264: 2%

$23,265 to $36,714: 4%

$36,715 to $50,968: 6%

$50,969 to $64,414: 8%

$64,415 and up: 9.3%

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3. Determine your combined rate by adding the answer from question 1 to the answer from question 2. For example, if your federal tax bracket is 36% and your state tax bracket is 9.3%, you’d have a combined marginal tax bracket of 45.3%.

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4. Current yield on taxable corporate bonds**?

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5. Current yield on the type of Treasury issue you are interested in (ranging from 3-month bill to 30-year bond; all are exempt from state income taxes)**?

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6. My taxable-equivalent yield on Treasury issues. To determine the taxable-equivalent yield, divide the Treasury yield listed above by the inverse of your state tax rate. (If your state tax rate is 9.3%, or 0.093, for example, you would subtract that number from 1. The result: 0.907. Consequently, if the going Treasury yield is 6%, your taxable equivalent yield is 6 divided by 0.907, or 6.615%.)

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7. Current yield on California double-tax-free municipal bond (use a maturity range similar to the one you used for the Treasury issue; don’t, for example, compare short-term Treasury bill yields with yields from long-term municipal bonds)**?

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8. My taxable-equivalent yield on tax-free municipal bonds. (Divide the answer on line 6 by the inverse of your combined federal and state tax rate. For example, if the yield on municipal bonds is 5% and your combined state and federal tax rate is 45.3%, or 0.453, you’d subtract 0.453 from 1, to get 0.547. Divide 5 by 0.547 to find your taxable equivalent yield of 9.14%.)

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9. Compare the results for questions 4, 6 and 8. If you are in a lower tax bracket, your yield is likely to be highest on the taxable corporate bonds. However, if you’re in a higher bracket for either state or federal taxes, a tax-free bond may land you more after-tax income.

* The state and federal tax brackets listed here are for the 1996 tax year.

** Obtain current numbers from a broker or a daily newspaper. In The Times, you can find an index of yields on taxable corporate bonds and yields on Treasury issues in the Money Rates chart on the Market Roundup page (today on DX). In addition, an index of yields on California municipal bonds is in the California Municipal Bonds chart that runs Tuesdays in Wall Street, California (today on DX). If you prefer to compare the yields on specific bonds, call a broker, but make sure the bonds you are comparing have like maturities and default risks. You want, for instance, to compare a 30-year AAA-rated municipal to a 30-year AAA-rated corporate to a 30-year Treasury.