Factors to Consider in Weighing Shift to Bonds

The U.S. Treasury’s surprise decision Wednesday to stop issuing 30-year bonds sent investors scrambling to lock in yields on other long-term government issues, as well as on high-quality corporate and municipal bonds.

The rally added to what had been a great year for most types of bonds, as falling market interest rates in the weak economy have boosted the value of older fixed-rate securities. Many mutual funds that own high-quality bonds have posted double-digit “total” returns, which is interest earned plus share price appreciation.

But with yields continuing to decline, is now the time to buy bonds--or would it be smarter to wait until next year on the chance that an economic rebound could boost yields?

Here’s a look at some of the issues bond investors and potential bond investors face now:

Question: Are bond yields likely to continue falling because of the Treasury’s decision?

Answer: For now, the move to stop issuing 30-year bonds could drive more investors to try to lock in yields on other long-term issues, experts say.

But that would mostly benefit high-quality bonds in the government, corporate and municipal sectors.

The highest rates available today are on corporate junk bonds, but in a weak economy many investors are reluctant to buy such risky securities.

If the economy continues to sink, it is likely to push rates on all types of high-quality bonds lower. But how much lower is anyone’s guess.

Question: Do all bond mutual funds that focus on high-quality issues stand to benefit the same from falling long-term rates?

Answer: No. It depends on the type of bonds owned and their maturities.

The majority of bond funds own mostly shorter-to intermediate-term bonds, meaning securities maturing within seven years or so. Yields on shorter-term issues already have fallen sharply this year thanks to the Federal Reserve’s nine reductions in its key short-term interest rate.

If you own a bond fund or are considering buying one, look closely at the type of bonds it owns and the average maturity, or “duration.”

Question: If interest rates rebound next year because the economy revives, won’t bond funds suffer?

Answer: They could indeed. Just as bond fund share values are rising now as market interest rates fall, a rebound in rates would make older bonds less appealing and depress their values.

Question: If I want to own bonds for diversification sake, but I’m afraid of interest rate whiplash, what’s a good strategy now?

Answer: Though the economy looks bleak at the moment, “the effect of these coordinated policy actions by the Federal Reserve and now the Treasury will eventually lead to a response,” said Steve Kane, portfolio manager at Metropolitan West Asset Management in Los Angeles. “We look for the U.S. economy to respond robustly.”

Investors who feel confident about a recovery may want to look at investment-grade corporate bonds, said Gary Madich, chief investment officer for fixed income at Banc One Investment Advisors in Columbus, Ohio.

An improving economy could make investors more willing to buy corporate bonds instead of super-safe Treasuries or other government-agency debt. Plus, yields are higher now on corporate bonds than on Treasuries.

Kane said many corporate bonds offer good value these days. “They look extremely attractive in terms of yield spread to Treasuries,” he said. Ten-year notes from Ford Motor Co., for instance, pay 2.85 percentage points more than 10-year T-notes.

“That spread is as wide as it has been for at least 10 years,” he said.

For those willing to take significant risk, junk bond funds also may be worth a look.

Question: What other types of bonds might fare well?

Answer: David MacEwen, chief investment officer for fixed income at American Century Investments in Mountain View, Calif., said long-term tax-exempt municipal bonds might hold up well.

California long-term munis, for example, “look like a pretty good value right now,” he said.

Munis are “still a good buy for someone who wants or needs tax-free income,” Madich said.

Whatever type of bond you consider, it could be smart to buy gradually over the next year instead of putting a chunk of money to work now.

“For most people, dollar-cost averaging into the market is always one of the most sensible ways to go,” Kane said. Such a strategy tends to protect investors from poorly timing their bets.

Question: What if I invest primarily through a 401(k) savings plan?

Answer: For investors looking to add a bond fund to their 401(k) account, their choices may be very limited. Though the average 401(k) plan has about 12 funds to pick from, often there will be just one bond fund or “two at most, perhaps a corporate fund and a government fund,” said David Wray, head of the Profit Sharing/401(k) Council of America, a Chicago-based association that works with plan sponsors.

The majority of 401(k) plans also offer a balanced (stock and bond) fund. But investors should note that balanced funds can vary greatly in their performance and in their asset mix.