Steady strategies for a baffling bond market

By Kiplinger's Personal Finance Magazine

It wasn't supposed to happen like this. For the last two years, many investors have avoided buying bonds with maturities extending further than five years. Their reasoning: Once the Federal Reserve started raising interest rates, long-term rates would surely head up, too. Because bond prices go down when yields go up (and vice versa), anyone already holding long-term bonds would lose principal if they sold.

But the bond market threw investors a curve ball. When the Fed started raising short-term interest rates in June 2004, the 10-year Treasury note yielded about 4.6%. Despite eight short-term rate hikes of 0.25% each, the 10-year note last month inexplicably dipped below 4%. The drop in long-term rates befuddled even Fed Chairman Alan Greenspan, who has called the anomaly a "conundrum."

So what's an investor to do? Though one can never be sure, the bond market is unlikely to continue its bizarre behavior much longer. With wages rising and the threat of inflation looming, the Fed will continue to ratchet up short-term rates until they reach 4.25% or so early next year. This push will eventually force up long-term rates: The 10-year note will rise to 4.75% by the end of this year and reach 5.5% by the end of 2006.

Betting on interest rates is risky

In a June report to clients, Smith Barney strategists George Friedlander and Michael Brandes advised bond buyers not to try to bet on bond-rate shifts, either up or down. They illustrated various strategies with four hypothetical portfolios.

Their first hypothetical portfolio has a collection of bonds with an average maturity of three years, plus a large amount of cash. Such a strategy is appropriate only if the investor doesn't need much income and is highly confident that rates will rise sharply.

The second portfolio has bonds with maturities ranging from three to eight years and a moderate amount of cash. This is fine for an investor who is satisfied with the portfolio's moderate income and reasonably confident that rates will move higher, with the 10-year Treasury note rising to about 5.25% this year.

Portfolio three has bonds that mature in five to 13 years and a moderate cash allocation. This portfolio makes sense for an investor who needs significant income and who does not expect rates to go much higher.

Portfolio four's bonds mature in five to 20 years, and its cash holdings are small. An investor with this portfolio is betting that rates will decline.

Of the four portfolios, numbers one and four are risking a lot on their presumptions about bond-market movement. For most investors, portfolios two and three are diversified enough to provide the best defense against a swing in interest rates, whether higher or lower, Friedlander and Brandes say. As recent history shows, it's tough to guess which direction interest rates will move.

Ladders, barbells and bullets

There are several ways you can invest in bonds for steady interest income even if rates don't pan out as expected. The most effective strategy for buy-and-hold investors is the bond ladder. You can ladder CDs, U.S. Treasurys, municipal and corporate bonds.

Here's how a ladder works: You even out your risk by spreading your money among bonds that mature at selected intervals. For example, you could buy bonds that mature in one, two, three, four and five years to form a five-year ladder. Bonds in the first rung of your holdings mature after one year. When they mature, you reinvest the money in five-year bonds. Each succeeding year, as the bonds in a rung mature, you reinvest the proceeds in five-year bonds. The result is a stream of interest income and a return of a portion of your principal as each batch of bonds matures.

Even when yields fall, bond ladders can still smooth out your interest income. Because only a portion of your bonds matures each year, the higher-yielding bonds you locked in earlier will continue to provide higher interest income.

No one can forecast with certainty where interest rates are headed, so it's impossible to plan a ladder's maturities perfectly. However, for most investors today, a five- or 10-year ladder is adequate.

Another bond strategy is called the barbell. You choose two maturities: one short and one long. For example, half your bond holdings might be in three-month Treasury bills and the other half in 10-year Treasury notes. The two maturities together carry the same interest rate risk as a five-year laddered portfolio.

Aiming for a win

The third approach is the bullet, wherein an investor picks bonds that all mature at the same time. Hitting the bull's-eye requires an awareness of market prices and a willingness to adjust the portfolio as interest rates shift up or down. Take U.S. Treasurys as an example. At current rates, it appears that investors who stretch maturities beyond two years aren't being compensated for the added interest-rate risk they're taking. A Treasury note maturing two years from now, in June 2007, was recently yielding 3.6%, while one maturing five years from now, in June 2010, was yielding just 3.7%. So today's investor may decide that two-year Treasurys are the way to go--a two-year bullet, so to speak. Track bond yields at www.investinginbonds.com.

You can buy Treasurys directly from the U.S. Treasury at auction at www.treasurydirect.gov. If you prefer to buy Treasurys or other kinds of bonds with specific maturities in the open market, consider Fidelity's unique bond service, which helps you determine whether you're paying a fair price. Treasury bonds cost 50 cents each to trade online at www.fidelity.com; municipal bonds, $1.50; and corporate bonds, $2. You won't pay more than a $500 commission per total order, regardless of the quantity of bonds. The minimum charge is $19.95.

Bonds or bond funds?

If you plan to invest in bonds other than super safe Treasurys, consider investing in a bond mutual fund rather than managing your own portfolio. You'll get instant diversification and expertise. Stick to short- and intermediate-term bond funds so you won't get caught off base when long-term interest rates move up.

A key to picking the right bond fund is paying close attention to fund expenses. Vanguard is the low-price leader in the bond-fund world. You could split your money between Vanguard Short-Term Bond Index, which recently yielded 3.75%, and Vanguard Intermediate-Term Bond Index, which recently yielded 4.32%. If you're in the 25% federal tax bracket or higher, you may come out ahead with municipal bond funds, such as Vanguard Short-Term Tax Exempt (recent yield, 2.55%), or Vanguard Intermediate-Term Tax Exempt (3.31%). You can also invest in single-state muni bond funds.