Time to Buy Bonds?

A bond is defined as an interest-bearing certificate issued by a government or business, promising to pay the holder a specified sum on a specified date.

Common wisdom says bonds are a safe haven from stock market turmoil. Does that mean you should buy bonds if that turmoil comes from recession or inflation?

Complicating the situation is the fact that there is no one-size-fits-all-situations bond. The Treasury Department issues bonds, so do corporations, municipalities and banks. There are short-term bonds and long-term bonds; bonds with pristine credit ratings and junk bonds.

Remember, while bonds may protect you in hard economic times from the deep dives that stocks sometimes take, there is no guarantee you won't lose money. With bonds, you can get hurt while standing on the sidelines.

Stability Versus Volatility
It's a given that most people, especially as they near retirement and need to reduce volatility in their portfolio, should have a smattering of bonds for stability and to provide fixed-income.

The ratio of bonds to equities and cash depends on your needs and your risk tolerance. We won't specifically address allocation in this article, but we will try to provide some guidance for when it's appropriate to load up a bit more on your bond allocation.

Cash, U.S. Bonds and Foreign Bonds
David Marotta, president of Marotta Asset Management in Charlottesville, Va., includes three asset classes in the stability portion of his clients' portfolios.

The first is "short money," comprised mainly of money markets and, occasionally, short-term CDs; assets that mature in less than two years. Second is U.S. bonds, and the third is foreign bonds.

"Short money has probably been the riskiest investment over the past couple of years," says Marotta. "The dollar has dropped in value and its buying power has dropped tremendously. By proxy, the second riskiest investment is U.S. bonds. They've appreciated some in the recent market downturn, they've paid a little bit better interest rate, but in terms of purchasing power, they've been one of the worst investments in the last two years.

"Foreign bonds do the best during a recession and during inflation. During a recession, the bond category as a whole will do well, but during inflationary times, the U.S. dollar is dropping in value. Your foreign bonds are going to get both the good return you get in a bond portfolio during a recession and an extra kick because the value of the U.S. dollar is dropping.

"When the dollar drops, your foreign bonds are going up in value because they're invested in foreign currencies, which aren't being devalued as much as the dollar. When you invest in foreign bonds in this mode, you want to invest in unhedged foreign bonds."

Hedged Versus Unhedged
Since individual bonds can be too pricey for many individual investors, consider bond funds. An unhedged foreign bond fund is one that is denominated in foreign currencies. Sometimes the word hedged or unhedged will be in the funds title, such as PIMCO Foreign Bond (Unhedged). If it's not noted in the fund name, check the fund's description or profile.

You're deliberately exposing yourself to currency fluctuations when you buy an unhedged bond or bond fund. A foreign bond fund that is U.S. dollar hedged will limit its exposure to foreign currencies. In other words, you're limiting your exposure to currency fluctuations.

Treasury Bonds
James Shelton, chief investment officer at Kanaly Trust Co. in Houston, says this isn't a good time to buy Treasuries, and think twice before buying corporate bonds. Keep in mind that when bonds become popular, the price you pay for a bond rises and the yield drops. When bonds are unpopular, the price is low and the yield is high as bond issuers try to entice investors to buy.

"Treasuries are very expensive today. The time to have purchased themwould have been in the middle of 2007. We don't believe the Treasurymarket offers very good value at this point," says Shelton.

"With inflation around 4 percent, you're getting a negative real rate of return. The only way I think it makes sense to buy a 3.5 percent 10-year Treasury bond today is if you think the yield is going to 3 percent, because then you'll gain from the price appreciation. But the economic outlook is going to have to get much worse for that bond to give you that kind of price appreciation."

10-year Treasury bond

Corporate bonds and municipal bonds
Corporate bonds can give you a better return than Treasuries because ofthe risk that the corporation may default on its obligation even if thebond has a good credit rating. But Shelton says that a slowing economicenvironment makes buying corporate bonds too dicey unless you'retalking about bonds from the bluest of the blue chips.

"Where I do think there is very good value is in the municipal bond market. If you look across the municipal bond yield curve,you're getting rates that are comparable to Treasuries but you don'thave to pay taxes on the yields. So, if you have a five-year Treasuryat 2.88 percent today versus a Triple-A-rated five-year municipal bondat 2.85 percent that you're not paying tax on, that's attractive."

Historically, tax-freemunicipal bonds yield approximately 80 percent of their Treasurycounterparts. But the spread has narrowed significantly the past year.As of this writing, the five-year Treasury is yielding 2.77 percentwhile the average five-year municipal's yield is 2.69 percent;approximately 97 percent of the Treasury.

Do the math
Here's how to determine if a tax-free municipal bond will give you abetter return than a Treasury of equal maturity. We'll use the abovenumbers for this example and we'll assume a marginal tax rate of 28percent.

After tax return = Rate of return (on the taxable bond) x (1-marginal rate)

1.99 percent is the after-tax return on a Treasury that's yielding 2.77percent when the marginal tax rate is 28 percent. Clearly, themunicipal bond yielding 2.69 percent is the better investment.

Inflation-protected bonds
Inflation-protected securities should do better in inflationary times,but investors have driven up the price of some inflation-orientedsecurities and that's made them a bit pricey.

An exchange-traded fund that seeks to shadow the inflation-protected sector of the U.S. Treasury market is the iShares Lehman TIPS bond, symbol TIP. Year-to-date, as of this writing, it has returned 3.96 percent. For the last quarter of 2007, it returned 11.44 percent. However, if you're late to the party, don't buy it now. The per-share price is $108.79 and financial advisers we've spoken with say it's too expensive to buy; a share price of $100 is more reasonable.

Definitions

• Yield curve -- A graph that shows the relationship between yields and maturity dates at a given point in time. • ETF -- Exchange-traded funds hold a basket of securities like mutual funds and trade like a stock. See the Guide's Glossary for a further explanation of these terms.

Another Treasury product is the I-bond, a savings bond with avariable-rate component that's meant to offset inflation. The currentannual interest rate is 4.28 percent. That may seem pretty decent but,unfortunately, the bond's fixed rate component, which stays with thebond for its 30-year life, is a mere 1.2 percent. The rest of the totalyield is the variable component which is adjusted semi-annuallyaccording to the government's inflation numbers.

"If inflation is running hot, the inflation-protected securities will do better than the non-protected securities, but I think the U.S. government underreports inflation, so you may give up a little bit because of that," says Marotta.

High-yield
When the economy heads south, high-yield bonds -- sometimes referred toas junk bonds -- can be enticing. It's easy to see how an investorcould gravitate toward a struggling Ford Motor Co. that's scroungingfor money by issuing bonds paying nearly 10 percent.

Jayme Wiggins, a certifiedfinancial analyst at Intrepid Capital Funds, manages the high-yieldIntrepid Income Fund. He says that a year ago he couldn't find muchworth buying because the yield difference between Treasuries andnon-investment grade corporate bonds was maybe 250 basis points. Thanksto tough times, Wiggins says he's now finding spreads in excess of 700basis points.

"You're looking at double digit yields on high-yield bonds," saysWiggins, "but you have to be very careful about what you buy. We'reemphasizing higher quality credits that have gotten brought down witheverything else, but we know their balance sheets are good enough toweather a recession.

"In the last seven to 10 years,the return of the high-yield market has actually approximatedequity-type returns but with about half the volatility of the averageequity. Even if a bond's price declines by 10 percent, if it's payingan 8 percent coupon-- which is reasonable for a high-yield issuer -- over the course of ayear it's only down 2 percent because you're accruing that coupon.Unless an equity is paying an 8 percent dividend, and most of themaren't, it's hard to outrun a high-yield coupon. I'm not sayinghigh-yield is better than equities, but I think it's a valuablediversifier."

Bonds for $1,000
Individual bonds can be extremely expensive for individuals withmoderate portfolios. Bond funds and bond exchange-traded funds are away around that, although you'll probably get somewhat less return.

One way to buy individualcorporate bonds cheaply is through a product called InterNotes. They'reprimary issue, investment-grade corporate and government agency bondsmade available only to individual investors. Each bond sells at par,$1,000, the minimum investment, and they can be purchased in incrementsof $1,000. The bonds are issued weekly and are typically available forpurchase for five business days. You can buy them through mostbrokerages. Tom Ricketts, chief executive officer at Incapital, thecompany that offers InterNotes, says he hasn't seen the spread betweenTreasuries and corporates this large in a decade.

"The reason corporate spreadsare out is not because anyone thinks GE has any risk of default, it'sjust because fewer dollars are bidding for the same number of bonds. Sospreads move out and that's when you should be buying. It's a temporarything. The institutional markets control the pricing for bonds and whentheir liquidity dries up a bit, when they don't have as much cash, thencorporate spreads balloon.

Definitions

• Coupon -- The interest rate on a bond. It's expressed as an annual percentage of the face value. A bond that pays 6 percent interest has a 6 percent coupon. See the Guide's Glossary for a further explanation of these terms.

"There's a great relative value in corporates that will last maybe forsix months and as market conditions improve, and liquidity improves,those yields premiums come back in so you get less relative value toTreasuries."

Maintain an appropriateallocation of bonds and you won't have to worry about timing themarket. But if you want to increase your bond allocation during certaineconomic cycles, do your homework and maybe you'll buy and sell aheadof the crowd.

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