Stodgy but stable, bonds dampen market's drafts

Bonds are suddenly "in."

The numbers for the first quarter tell the story dramatically. With two exceptions, all major bond indexes measured by financial information firm Lipper Inc., are in positive territory and gaining ground.

Most stock indexes, by contrast, were in negative territory.

Lipper's high-yield (junk) bond index led the fixed-income pack, up more than 3 percent. Other domestic bond products are also up, including corporate issues, US Treasury and agency bonds, and municipal bonds.

Only global-income and international-income indexes are down. But even here, global-bond experts such as Stephen Smith of Brandywine Asset Management in Wilmington, Del., stress that the world-bond market appears to be positioning itself for growth down the road.

"We've said it now over and over: Bonds should be an important component of one's overall portfolio, based on a person's long-term goals and investment-time horizon," says Michelle Smith, executive director of the Mutual Fund Education Alliance in Kansas City, Mo.

At their best, says Ms. Smith, bonds offer investors a number of significant advantages, including stability of income, tax advantages, and diversification.

Bonds, she says, can have sharp downdrafts, as do stocks. But owning fixed-income products is a good way to offset the erosion of value now occurring in the stock market.

Not only are bonds currently proving attractive to small investors - with money flows into bond mutual funds increasing weekly, according to the Investment Company Institute, the main trade group for the fund industry - but bonds are shoring up bottom-line profits for Wall Street investment houses.

Prompted by falling interest rates and a greater public interest in fixed-income products, new bond issues soared during the first quarter, especially in such sectors as telecommunications, finance, and autos.

Even the number of high-yield issues are up, sought out by institutional and individual buyers.

So how should the average investor take advantage of the new attractiveness of bonds?

"That clearly depends on their particular financial goals," says Smith. If they are a long-term investors, for example, with a 30-year time horizon, bonds will probably not be as vital a factor in their portfolio as growth stocks, which historically have done best over time.

If they are shorter-term investors, say with five to 10 years before retirement, bonds will obviously be a larger part of their portfolio, she says. Younger investors with high salaries may want to own municipal bonds for their tax-saving advantages.

Here are the major categories of bond products and a brief word on their prospects:

High yield: Returns have been quite good, yielding about 10 percent or better. High yields do well in an "uncertain" economic setting, such as now. But they tend to be riskier in a recessionary economy, when there is a greater danger of default by over-stretched companies.

Top-grade corporates: Next to high-yield issues, they have led the pack in terms of gains, and look promising for the rest of the year. Fund experts stress that for average investors, a general-purpose bond fund with a mix of corporate and government issues, or an intermediate-term fund, which holds bonds with durations of about five years, may make the most sense.

Such funds tend to be highly flexible. They also help an investor avoid risk, says Bill Stevens, chief investment officer for Montgomery Asset Management, in San Francisco.

"My intermediate fund is currently yielding around 6.3 percent," compared to around 4.5 percent for a US Treasury bond, says Paul Lundmark, portfolio manager of USAA Intermediate Term Bond Fund. Lundmark's short-term fund for USAA yields slightly less. For the past year, his intermediate-term fund has returned over 11 percent. For this year, it is up over 4 percent.

USAA also offers a general bond fund as well as funds linked to specific durations, as do most fund firms. The USAA Income Fund, a general fund, for example, is up just under 15 percent for the 12-month period ending in February.

Municipals: Issued by state and local governments, these bonds earn interest free of federal taxes, and in some cases also free of local and state taxes. (But appreciation is subject to capital-gains taxes. Be certain to check with the issuer as to a given bond's tax characteristics.)

Defaults have been very rare. The spread between the real (tax-adjusted) return of municipals and corporate bonds has also been decent - driving the market upward for munis.

US Treasuries: These pay a lower interest rate than corporate issues, but are backed by the US Government. Thus, they are the ultimate "safety" products of the bond market, although they still carry interest-rate risk, as yields move up and down.

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The basic bond lexicon

Bond: An IOU from a borrower (such as a corporation or government agency) to whom you have lent money. A bond does not represent ownership in a firm. That's a stock.

Callable bond: A bond that can be redeemed by the issuer before the stated maturity date, its "due" date. Rule of thumb: Always check on call provisions when buying an individual bond.

Quality: The bond's rating, determined by such services as Moody's and Standard & Poor's. Top (investment grade) bonds have all A's or B's or a combination, and are expressed in three digits. (AAA, S&P, for example.) High-yield (junk) bonds run from Ba (Moody's) or BB (S&P), through the C's. The grades also show market risk.

Liquidity: The ease by which a bond can be sold. Higher grades usually equal greater liquidity.

Principal: The amount you invest in a bond. You are supposed to get it back at maturity (end of the bond's term).

Interest: What the borrower pays you for lending the principal.

Secondary market: Just as with stocks, some investors want to buy previously issued bonds. Prices for these bonds vary daily, based on market conditions.

Markup: The profit the dealer gets for selling the bond. It is tucked within the bond price and not easily identifiable.

Bearer bonds: They are assumed to belong to whomever possesses them. Bearer bonds have coupons you clip and mail in to get your interest payment. However, most bonds are now registered - that is, they have no coupons. Interest is mailed to the holder of record.

(c) Copyright 2001. The Christian Science Monitor