Seeking refuge from a turbulent stock market, Americans are investing in bonds in a big way.
The amount of new money going into taxable bond funds totaled $24.3 billion for the first three months of 2002, according to the Investment Company Institute, the mutual fund industry’s trade association. That’s up 14 percent from $21.3 billion in new bond fund money for the same period a year ago.
And 2001 was a stellar year for bond funds, with $76.1 billion in new money, a major reverse from 2000, when investors took $35.6 billion out of taxable bond funds, according to ICI.
Pacific Investment Management Co., the nation’s largest bond fund company, reports new money flowed into its Pimco bond funds at an average rate of $2.2 billion a month this year. That’s double the average inflow of $1 billion a month last year, which in turn was more than double the average of $450 million a month in 2000.
The huge upswing in new bond fund money reflects a renewed interest in a diversified portfolio. “People are back to asset allocation,” says Pimco spokesman Phil Neugebauer. “Regardless of what they’re doing on the equity side, they are putting 25 to 30 percent in fixed income.”
As a diversification tool, almost every money manager acknowledges that bonds have a place in most portfolios. Yet they say individual investors often are less familiar with the investment principles behind bonds than stocks. Bonds, which are loans to governments and corporations, are a safer investment than stocks. While your chances of reaping a 20 percent annual return with bonds are far fewer than with stocks, you’re also far less likely to incur a 20 percent loss, which many stock investors have had to swallow recently.
“We’re in a period where investors are likely to be earning single-digit returns,” says Steve Norwitz, vice president of T. Rowe Price Associates in Baltimore. “When you look at yields on bonds relative to stocks, bonds look attractive. If you end up earning an average return of 8 or 9 percent in stocks and can get 6 to 7 percent in bonds, that’s a favorable tradeoff,” he says, because bonds are inherently less risky.
While stocks may perform better over the long haul, bonds outpaced stocks significantly last year, according to Chicago-based research firm Ibbotson Associates. While the Standard & Poor’s 500 index was down 11.9 percent in 2001, the Lehman Brothers Aggregate bond index was up 8.4 percent.
Indeed, according to Ibbotson, bonds in most categories were up: Long-term corporate bonds rose 10.7 percent, high-yield corporates 5.3 percent, intermediate government bonds 7.6 percent, long-term municipals (which are free from federal tax) 4.9 percent, long-term government bonds 3.7 percent and the 30-day Treasury bill 3.8 percent.
Convertibles, which are a bond-stock hybrid, declined 5.9 percent and foreign government bonds dipped 3 percent. Early results show bonds this year are off to a slower start, about flat with last year.
Historically, for the 75 years from 1926 to 2001, the total return for corporate long-term bonds averaged 5.9 percent a year, compared to 10.7 percent for the S&P 500. And from 1985 to 2001, the total return for corporate long-term bonds averaged 10.6 percent compared to 15 percent for the S&P 500.
While the returns for bonds has increased, so has the so-called “standard deviation,” or risk measure. It averaged 8.7 percent from 1926 to 2001, rising to 10.3 percent for the more recent period of 1985 to 2001. “There’s a lot of fluctuation in bond prices now that didn’t used to be there 30 years ago,” says Clay Singleton, vice president at Ibbotson Associates. “Bonds are not as risky as stocks, but they are not the safe haven many people believe.”
Some bonds are riskier than others. Generally, higher-yielding bonds carry a bigger risk that you could lose money if the issuer defaults, interest rates rise, or the underlying mortgage is prepaid sooner than expected. The life of a bond also determines the yield, with shorter-term bonds paying less because they are less sensitive to interest-rate fluctuations.
In the current economic environment, when it seems that interest rates have nowhere to go but up, many investors are choosing short- or intermediate-term bonds. In addition, the yield on intermediate bonds currently isn’t much less than the yield on long-term bonds, so you would gain little by buying a long-term bond today.
What proportion of your portfolio should be in bonds? That depends where you are in your so-called “investment lifecycle.”
If you’re saving for retirement and you’re only 20, bonds probably will have a small place in your investment portfolio. If you’re 20 and saving to buy a house five years from now, bonds make more sense. Likewise, if you’re 65 and approaching retirement, many advisers will tell you to move funds out of stocks and into bonds.
“Every investor should have a rainy day fund,” says Paul O’Brien, portfolio manager at Morgan Stanley Investment Management in West Conshohocken, Pa. “With bonds, you’ll have a lot more confidence that you’ll get the income you expect year in and year out.”
So how do you know what types of bonds to buy? Unlike buying individual stocks, buying individual bonds can be complicated and expensive, because many bonds are only sold in blocks of 10,000. It’s also important to diversify.
“You must own many different bonds from many different issuers so that your portfolio will not suffer should one of those issuers default,” O’Brien says. That’s why most individual investors choose from a wide array of bond funds. But even those can be confusing to the novice.
The key sectors
The bond market consists of five main sectors–Treasuries, mortgage-backed securities, agency debentures, corporates and high-yields–that individual investors should understand, says Ashok Bhatia, portfolio manager at Strong Capital Management in Milwaukee. Other money managers add municipal bonds to the list.
– Treasury bonds, which are loans that investors make to the U.S. government, are backed by the full faith and credit of the government. While short-term T-bills are considered risk free, it’s important to remember that longer-term Treasury bonds are susceptible to interest rate changes, says Scott Dolan, senior portfolio manager at Deutsche Asset Management and Scudder Funds in Chicago. As interest rates rise, the price of the bonds will go down. This type of interest rate risk is known as duration risk.
Treasuries are the benchmark against which other types of bonds are measured. After all, if you can get the same rate with a Treasury bond that you can with a corporate bond that carries more risk, investors should go with the Treasury.
– Mortgage-backed securities are bonds backed by a pool of mortgages, usually residential. They have very high credit ratings and may be backed by the government in the case of Ginnie Maes (Government National Mortgage Association), or an agency like Fannie Mae (Federal National Mortgage Association) or Freddie Mac (Federal Home Loan Mortgage Corp.). Generally, these securities pay 100 to 150 basis points (1 percent to 1.5 percent) more than a Treasury bond, but they carry some prepayment risk.
Commercial mortgage-backed securities cannot be prepaid or only with a penalty, but they do have some credit risk, which residential mortgage-backed securities do not, O’Brien says.
– Agency debentures, which are backed by the credit of Fannie Mae and Freddie Mac, carry very high quality ratings and generally boast a yield of 40 to 70 basis points higher than Treasuries. While their return is a little less than mortgage-backed, you don’t have to worry about prepayment risk, Bhatia says.
– Corporate bonds are loans that investors make to corporations. They are graded based on the credit quality of the underlying corporation. Generally, the higher the grade the bond receives, the lower the risk and return. So-called investment-grade corporate bonds are rated triple-B or better. “At times like these when there is stress in the economy and some companies have had to default, corporate bonds have to offer a higher yield to get investors to bear those risks,” O’Brien says.
– High-yield bonds, also known as junk bonds, are loans to lower-graded corporations. These bonds carry a higher default risk and pay a higher yield than investment-grade bonds. In the current economic environment, where many corporations were downgraded due to general uncertainty following the recession, Sept. 11 attacks and Enron debacle, experts suggest high-yield bonds can be a savvy investment. If the economy does recover, these corporations are likely to do better and less likely to default on their loans.
– Municipal bonds are loans to local and state municipalities. Because investors don’t have to pay federal income tax on the interest they collect from munis, these issues come with a different formula for determining how they stack up, says Eric Jacobson, senior analyst at Morningstar Inc. “If you’re in a 28 percent or higher tax bracket, chances are you can do better with a municipal,” he says.
Here’s how to calculate what you have to earn on a taxable fund to beat the muni: Take the yield on the municipal bond and divide by 100 percent minus your tax bracket. So if the municipal bond is paying 9 percent and you’re in the 28 percent bracket, you would need a taxable yield of more than 12.5 percent to beat it.
When evaluating bond funds, don’t overlook the fees, Jacobson adds. “You don’t want to pay too much more than 0.6 or 0.7 percent ballpark,” he says, noting, “There are terrific funds at modest fees out there.”
He particularly likes a core bond fund like Pimco Total Return, Metropolitan West Total Return and Vanguard Total Bond Market Index, all of which try to match the performance of the benchmark Lehman Brothers Aggregate index.
Take taxes into account
In addition, taxes can be an important consideration with bonds, because unlike stocks, which appreciate over time, bonds pay regular interest, which is taxable. “If you’re going to own corporate bonds, you want to get them into a retirement or tax-deferred vehicle. Otherwise you’re going to be paying tax on your gains,” O’Brien says.
So, is now a good time to buy bonds? While Bhatia doubts bonds will be up 8.4 percent again this year, as they were in 2001, he says it’s likely bonds will finish 2002 up in the mid-single digits. “What makes bonds have a bad year is if the stock market finishes the year up 15 or 20 percent. Then it’s likely bonds will have a substandard return.” But if you are diversified, he adds, “your overall portfolio should do pretty well.”
A look back at bonds
A look at the total returns of various segments of the bond market over the last 10 years.
%% BOND TYPE/BENCHMARK 3 MONTHS 1 YEAR 3 YEARS 5 YEARS 10 YEARS
Corporate bond funds
(A-rated) -0.43% 3.82% 4.99% 6.38% 6.89%
Ginnie Maes 0.76 5.36 6.10 6.78 6.65
High yield 0.99 -0.94 -1.52 1.52 5.81
Municipal 0.79 2.75 3.33 5.05 5.94
Lehman Aggregate 0.09 5.35 6.49 7.57 7.38
%%
Sources: Lipper, T. Rowe Price
