You’re probably feeling pretty chipper these days if you’re a stock investor. Not only did equities sizzle in 1995, but even after a bumpy June, the Dow Jones industrial average is up 11.8 percent this year. Bondholders, on the other hand, are a bit blue. The Lehman Bros. Long Treasury Bond index, up a solid 30.7 percent in 1995, has declined 8.4 percent so far this year.
And compared with the torrents of cash surging into stock funds this year, bond fund inflows look like the Los Angeles River in mid-August.
That’s going to change. A number of market analysts believe that over the next 12 months the outlook is better for bonds than for stocks. How much better? If interest rates fall 1 percentage point within 12 to 18 months, bond investors could see returns as high as 30 percent, depending on the type of bond they own and its maturity. The obvious conclusion: It’s time to shift the balance in your portfolio–to pull back on stocks and put more money into bonds.
As anyone who owned bonds in 1994 can tell you, following this strategy is not risk-free, by any means. But for now, the bond market’s hazards seem subdued. Inflation, fixed income’s mortal enemy, was just under 3 percent over the past year, and many economists expect it to remain there.
Says Bruce Steinberg, senior economist at Merrill Lynch: “Outside of food and energy prices, inflation is running at its lowest rate in 30 years.” So there’s less pressure for the Federal Reserve to choke off climbing prices by raising interest rates.
OK, you may ask: If the case for bonds is so compelling, why isn’t everyone stampeding into them? The catch is that during the next month or two, the economy could look stronger and the Fed, hyperventilating about inflation, might raise rates another half a percentage point.
But that would only speed up the inevitable economic slowdown, says Kathryn Lunstrum, chief investment strategist at Duff & Phelps in Chicago.
Jim Conroy, co-manager of the Smith Barney Diversified Strategic Income Fund, agrees that you should forget near-term rate jumps and focus on where rates are likely to be in six months or more. “Rates might go up another half a point or so,” he says, “but it’s definitely time to start moving into fixed income.”
Today, most experts suggest allocating 35 to 50 percent of your portfolio to bonds. And after the recent 18-month surge in stocks, odds are that your portfolio is listing considerably more toward stocks than that. So swapping some of your most levitated shares for bonds not only brings your portfolio back into balance, it’s also a way of forcing yourself to sell high.
To get the best combination of safety and return, confine your buying to Treasury, government agency and municipal issues or mutual funds that invest in them. Here’s what the two dozen economists, investment strategists and fixed-income managers we canvassed think you should be investing in now, starting with the safest choices:
– Treasuries. Backed by the full faith and credit of the U.S. government though they are, Treasury issues will fluctuate in response to interest-rate moves. The longer the maturity, the greater the price swings. For that reason, our experts advise that you buy intermediate-term, 7- to 10-year notes.
“Shorter-term securities will get hit much less than 30-year bonds should the Fed raise rates,” says James Solloway, director of research at Argus Research in New York City.
Moreover, the difference in yield is less than two-tenths of a percentage point. Take 10-year notes, currently yielding 6.9 percent. If rates rise by half a percentage point during the next year, the price of these notes will drop 3.4 percent, while the price of 30-year bonds, currently yielding 7.05 percent, will decline by 5.9 percent. Should rates fall by a full percentage point instead, says Liberty Financial investment strategist Porter Morgan, the price of the notes will rise 6.7 percent (versus 12.6 percent for the bonds) and, combined with interest income of 7 percent, provide a total return of 13.7 percent.
– Agencies. Certain federal agencies, such as the Federal National Mortgage Association (Fannie Mae), issue debt that is not explicitly guaranteed by the government but carries its implicit backing. (In other words, the feds aren’t making any promises, but no one thinks they’re going to let Fannie Mae default–ever.) Your reward for taking this scintilla of additional credit risk is a tad more yield. For example, Fannie Mae 10-year notes are currently yielding 7.16 percent, versus Treasuries’ 6.9 percent.
– Municipals. Because most munis issued by your state are exempt from federal taxes as well as your home state’s levies, munis usually beat comparable Treasuries of the same maturities for investors in the 28 percent bracket or higher.
James Cooner, head of tax-exempt bonds at the Bank of New York, points out that for those in the 31 percent tax bracket, an intermediate-term Treasury note would have to pay 7.6 percent (instead of its current 6.9 percent) to put as much money in your pocket as an intermediate-term AA muni.
As with Treasuries, intermediate munis offer nearly the same yield that their longer-term cousins do but with less volatility.
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Jim Lynch, editor of the newsletter Lynch Municipal Bond Advisory ($350 a year; 212-663-5552), advises confining yourself to issues rated AA or better by Moody’s and Standard & Poor’s because the difference in yield between these and lower-quality bonds is not enough to justify the risk.
