Stocks May Yield to Bonds in '97

Slowing economy, rising rates underscore attractive, predictable returns on bonds

Bonds are back!

From the titans of high finance like mutual fund guru John Templeton to top investment houses like Merrill Lynch, there's a new interest in fixed-income assets.

Bonds became financial wallflowers in recent years as investors tripped over each other to join the stock market dance.

Now, the dance cards have changed.

Federal Reserve policymakers boosted short-term interest rates in March and have raised the possibility of an additional rate hike, or even a series of boosts.

Rising interest rates in the economy mean rising rates (yields) on bonds.

Treasury bonds, for example, now yield close to 7 percent, an unusually high return for one of the world's safest investments.

Not surprisingly, bonds start to look attractive for investors chasing total return. And several major investment houses this year have reduced their recommendation for stocks and boosted their play in bonds.

A bond represents a loan. Treasury bonds are a loan from investors to the federal government, corporate bonds to companies, etc. Bonds pay interest to their owners. The riskier the bond, the higher the interest rate.

The US economy is expected to show modest growth for the rest of the year. With stocks now richly priced, that's an investment climate that could favor bonds over stocks.

That outlook led investment powerhouse Merrill Lynch to recommend that investors put 55 percent of their assets in bonds and 45 percent in stocks. That move is considered significant, since Merrill is one of the few houses that favor individual investors over large institutional accounts.

Charles Clough, Merrill's chief investment strategist, sees bond yields actually coming down in the months ahead, as the economy slows.

That means if you want to lock in a high rate, better buy now.

Financial advisers still recommend keeping the lion's share of your investments in stocks, which "out-perform bonds over time," says Thomas O'Hara, chairman of the National Association of Investors in Madison Heights, Mich.

But bonds or bond mutual funds add stability to a portfolio over time and could prove more attractive than stocks over the short term.

There are two basic ways to buy bonds: through a broker or through a mutual fund.

Brokers. A broker can buy bonds for a modest commission, ranging from $50 on a typical issue up to $100.

Most experts now recommend intermediate-term bonds of about five years, with yields close to long-term, 30-year Treasuries.

Five-year intermediate bonds, for example, yield around 6.5 percent, just below the 7 percent range of 30-year US Treasury issues.

The intermediate issue also gets a thumb's up because it can usually be held to redemption without being "called."

That's when the bond issuer recalls the bonds, pays off the investors, and usually issues new bonds at lower interest rates.

That saves the issuer - a municipality, for example - money, but it leaves the investor shortchanged on expected returns.

If you do buy bonds through a broker, financial advisers recommend a diversified portfolio, such as corporates, Treasuries, and junk bonds, a mix with diversification and high average yields.

Mutual funds. Bond funds give you broader diversification than you get buying individual bonds from a broker. But annual management fees eat up a chunk - perhaps one percentage point - of your total return.

Alas, bond funds have fared poorly in recent years. Some experts worry about more of the same if rates continue to rise this year. When rates rise, prices of existing bonds with lower rates fall.

In 1994, when the Fed boosted rates, bonds turned in "listless performances," says Sheldon Jacobs of No-Load Investor in New York.

Still, bond funds performed well in April, Mr. Jacobs notes. If you think more rate hikes are unlikely, you may want to jump into bonds now, he says. If you think rate bumps aren't over, you may want to wait, to get higher yields.

For the three years ending April 30, high-yield (junk bond) funds beat the pack, up 9.67 percent, according to Morningstar Inc. in Chicago. But they also have more risk than government or higher-grade corporate issues.

Long-term government bond funds have done well over time, up 6.84 percent for three years, but have fared poorly this year, down 0.59 percent for the four months through April 30.

Uncle Sam Forges New Bond With Investors

OVERNMENT savings bonds, the Tinkertoys of federal money crunchers, have been fiddled with again.

This time for the better, according to savings-bond experts.

A lot of folks complained they couldn't understand the way the bonds were computed. In addition, many bondholders groused about lousy returns, especially compared with returns on stocks.

The result hit the federal government where it hurt most - in the pocketbook. Sales fell from $17.5 billion in fiscal 1993 to $6 billion last year.

Someone who bought a Series EE savings bond in the past two years would earn 85 percent of the average market rate on six-month Treasury bills for the first five years. After that, the bond would earn 85 percent of the rate on five-year Treasury notes.

That's a complicated formula, one that makes it all but impossible for average investors to compare bond investments with other options.

The US Treasury has now simplified matters: All new bonds issued after May 1 will earn 90 percent of the five-year average on Treasury notes. (Old bonds will continue to earn money under the prior formula.)

Interest will now accrue monthly, not every six months.

The new rates should boost savings bond yields between 1 and 1-1/2 percent a year.

According to bond expert Daniel Pederson, a bond purchased last November yielded 4.56 percent on an annual basis. Under the new rules, the yield jumps to 5.85 percent.

He says "these are real positive changes for the bondholder," adding that early next year, the Treasury is expected to unveil a savings bond indexed for inflation.