Sizing Up Bonds -- Before the Fed Acts

Popular wisdom is that rising interest rates are bad all around.

But for many Americans, higher rates aren’t an enemy. They’re a friend.

The interest return on long-term U.S. Treasury bonds now is the highest in 22 months. That ought to get the attention of investors who are sitting with large sums in cash accounts that still earn next to nothing.

Rates on corporate and municipal bonds also have jumped this year. California recently paid an annualized tax-free yield of 4.22% on 10-year bonds used to refinance the state’s deficits of recent years. That was equivalent to a 6.2% fully taxable yield for an investor in the combined 32% federal and state income tax bracket.

The upshot, say many financial advisors, is that people who are wondering how they’re going to fund their retirement ought to consider what longer-term bonds can offer in interest earnings and principal preservation.

Popular wisdom may be stopping some investors from giving bonds a look. Everyone knows the Federal Reserve is expected to begin tightening credit this year, possibly as soon as June. Shouldn’t you wait for the Fed to formally raise interest rates before thinking about bonds?

That’s a common misconception, says Richard Lehmann, publisher of the Forbes/Lehmann Income Securities Investor newsletter in Miami Lakes, Fla. (www.incomesecurities.com).

The Fed controls short-term interest rates via its influence over the federal funds rate, the overnight lending rate among banks. The Fed has held that rate at a 46-year low of 1% since June.

But the central bank doesn’t directly control longer-term rates, such as what bonds pay. Those rates are determined by the actions of investors in the market.

When the economy is strong, as it is now, and investors perceive that the Fed will soon be raising short-term interest rates, bond yields tend to shoot up well before the central bank moves.

Likewise, long-term yields tend to begin dropping well before the Fed begins to ease credit.

Indeed, four years ago this month, 30-year Treasury bond yields were below yields on two-year T-notes. Investors had already begun to anticipate that the Fed would begin to lower rates (the central bank’s cuts began in January 2001).

“People need to understand that the long end of the bond market doesn’t wait around for the Fed,” Lehmann said.

The big question, of course, is how high all interest rates may go before they top out. Nobody would lock in a fixed annual rate of, say, 5%, on a long-term bond today if they knew they could lock in 7% a year from now.

A glance at a chart of bond yields since 1999 shows that current rates, though up sharply from their lows last year, remain well below their highs of 2000.

The annualized yield on the 10-year Treasury note, for example, has surged from a low of 3.11% in June to 4.77% now.

But the T-note yield peaked at 6.79% in 2000. Could rates get close to that level again? There’s no way to know for sure.

Many interrelated factors determine interest rates at any given moment. The Fed’s rate stance is one factor. The health of the economy is another. And inflation expectations also are key, because inflation erodes investment returns over time. If investors believe that inflation will rise substantially, they’ll demand higher bond yields to compensate.

A pickup in inflation has contributed to the rise in bond yields this year. On Friday the government said consumer prices rose at an annualized rate of 4.4% in the first four months of the year, up from 1.9% for all of 2003. Higher energy prices have been a major culprit.

Many economists believe that full-year inflation in 2004 will be somewhere between 2% and 3%. Longer-term inflation expectations also are in that range.

If those estimates are on target, it’s possible that long-term interest rates have further to rise. That’s one reason financial advisors generally aren’t telling clients to rush into bonds now. But people should at least begin nibbling, many advisors say.

“We’re saying you’re getting the best rates in two years. It’s time to start buying,” said Bill Hornbarger, fixed-income strategist at brokerage A.G. Edwards & Sons in St. Louis.

Many analysts have been stunned by how quickly long-term bond yields have rebounded this year, especially in light of the Fed’s pledge to go slow in raising short-term rates.

Bond yields are rising because some investors are bailing out (yields rise as bond prices fall). The selling has accelerated over the last two months. The 10-year T-note yield has risen a full percentage point since March 25.

Investors who are tempted to buy bonds might well ask why so many others are selling. It’s possible that the sellers have a better sense of what will happen with rates, longer term, than people who believe that current yields are relatively attractive.

But one factor driving the bond selling wave this year is that many professional investors and traders have been forced to scale back what had been a very profitable bet in recent years: the “carry” trade. That involves borrowing at short-term interest rates and using the proceeds to buy higher-yielding longer-term bonds. The profit is the spread between short-term and long-term rates.

That’s a great strategy as long as the Fed is holding short-term rates so low. Now that investors are sure the Fed will be boosting short rates, however, many investors are unwinding their carry trades, selling their long-term bonds and repaying their loans, Lehmann said.

“The long end of the bond market has been pounded,” he said. “It’s overdone,” at least for the moment, he said.

Others, however, worry that there are many more professional investors who will be dumping bonds soon.

“I think there’s a lot of money left to get out,” said Robert Gay, fixed-income strategist at Commerzbank Capital Markets in New York.

If interest rates continue to rise, any fixed-rate bond bought today would drop in value. If you had to sell it, you could lose money. So buying today, or anytime, carries price risk.

That argues for waiting to put money into bonds, some experts say. Except that trying to pick peaks in interest rates is like trying to pick bottoms in the stock market. Good luck.

Two groups of investors, in particular, ought to be thinking hardest about putting some money into bonds, financial advisors say.

One is the group that has been hoarding cash in short-term accounts such as money market funds or bank savings accounts. Yields on these accounts move in tandem with Fed rate increases. But with the Fed’s key rate at 1%, it would take dramatic moves to lift money market rates significantly.

“If you stay short, you’re going to give up a lot of yield” compared with shifting some of your money into longer-term bonds, said Eric Leve, fixed-income strategist at money management firm Bailard Biehl & Kaiser in Foster City, Calif.

The other group that should consider bonds: investors who are nearing retirement, have most of their financial assets in stocks and are nervous that the equity market might fail to produce decent returns over the next decade.

If you can lock in a yield on an individual bond (such as a Treasury note), that interest will be earned year in and year out. And when the bond matures, its face value will be returned to you.

The stock market, by contrast, guarantees nothing.

Financial planners like Mike Nozzarella at Tarbox Equity in Newport Beach say they prefer to use individual securities when building a bond portfolio, because that allows them to control yields, quality and the maturity dates of the bonds.

Investors of lesser means, however, often must use bond mutual funds. The disadvantage of the funds: Their yields fluctuate and there’s no set maturity. On the other hand, interest earnings can be automatically reinvested in the fund, which can compound returns over time.

Whichever bond vehicle you consider, the basic appeal is the same as interest rates rise: You’re earning a lot more than cash accounts pay, and you’re getting diversification that could be important to your overall portfolio return long term.

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Tom Petruno can be reached at tom.petruno@latimes.com.