April 15, 2008: 6:01 AM EDT
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How to invest in bonds

The fixed-income markets are a mess. Keep your maturities short, and don't forget about inflation.

By Katie Benner, writer-reporter


(Fortune Magazine) -- You count on bonds to be the quiet part of your portfolio, providing steady returns and offsetting the volatility of your stock holdings. Many retired investors count on bonds for regular income. Lately, though, the bond market has been anything but calm. The subprime-mortgage meltdown has roiled the credit markets and slowed the economy. In response, the Federal Reserve has cut short-term interest rates, helping to push yields to near-historic lows.

So how do you navigate this unfamiliar landscape? First off, if you have a well-diversified fixed-income portfolio or bond fund, it's probably held up pretty well so far. For example, Pimco Total Return (PTTAX), the giant bond fund managed by Bill Gross, has returned 3.7% since the beginning of 2008 and yields 4.5%, while Vanguard's Intermediate Bond index (VBIIX) has returned 2.7% since the beginning of the year and yields 4.7%. Both remain solid choices for your fixed-income dollars, especially if you are making periodic investments.

But if you're rolling over a lot of money from maturing CDs or shifting a big chunk of change from your stockholdings, we have some advice: Keep it short. Short maturities, that is. At current levels, you are not being paid very much for locking up your money in longer-term bonds (or certificates of deposit, for that matter).

Ultra-safe two-year Treasury notes yield only 1.9% (as of April 7), but the ten-year T-note is paying a mere 3.5%. (Bob Rodriguez, manager of FPA New Income bond fund, is so frustrated with rates that he's lowered his fund's average bond maturity from seven years to one.) The story is pretty much the same at banks. The average six-month CD rate is 2.7%, but increasing the term to five years barely moves the needle: The average is 3.1%.

While it's possible that interest rates will fall further, at some point in the next six to 12 months they are likely to start rising again as the economy recovers and demand for credit increases. "When short-term investments come due, you can reinvest back into the marketplace and take advantage of higher rates," says George Strickland, a managing director at Thornburg Investment Management.

For now, the best place to park your cash is a money market fund, a very short-term CD (check sites like bankrate.com for the best rates), or a short-term bond fund that won't suffer big losses when yields eventually rise. One reliable name is Vanguard Short-Term Bond Index (VBISX), which holds a mix of Treasurys and highly rated corporate debt. It has a $3,000 investment minimum, currently yields 4.4%, and has an ultra-low 0.18% expense fee.

Remember munis

A place to look for opportunities is the municipal bond market, which is awash in high-quality and very cheap choices that pay high, tax-free yields. "Muni bonds now pay much higher rates than Treasurys because of fallout from bond insurance problems," says Robert Corner, a portfolio manager at StableRiver Capital Management. "It's a rare opportunity because municipal bonds rarely yield more than Treasurys." One strong muni fund among many is Fidelity Short-Intermediate Muni Income fund (FSTFX). It holds cash and highly rated municipal bonds and has a 0.49% expense ratio, a $10,000 minimum investment, and a current yield of 3.1%.

Finally, many economists have warned that the Fed's rate cuts are creating the conditions for a sustained bout of inflation, which would erode the value of most bonds. That concern has driven up prices (and dropped yields) on Treasury inflation protected securities (TIPS), the only guaranteed inflation proof investment around. Ten-year TIPS yield just 1.8%, but that's still better than the 1.2% after-inflation yield on ten-year Treasurys. You can buy TIPS directly from the Treasury at treasurydirect.gov or via mutual funds at Fidelity, Schwab, T. Rowe Price, and Vanguard.  To top of page