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The best bonds to buy right now
The bond world is upside-down at the moment and advisors are calling for caution. But municipal bonds still offer safe, solid returns.
By Timothy Middleton
This is no time for fixed-income investors to take chances.
The interest rate on six-month Treasury bills (4.74%) is higher than that on 30-year Treasury bonds (4.66%). Thats called an inverted yield curve, and its as normal as Ted Kennedy and George Bush in the same saddle on Brokeback Mountain. It means cash is king.
With one exception: municipal bonds. At this moment, munis are beautiful.
A 30-year municipal bond is yielding a full percentage point more than a short-term note. For a top-bracket investor in a high-tax state like California, these tax-free bonds have yields that would equate to a 7.94% yield on a taxable bond.
Everywhere else across the fixed-income spectrum, though, its time to hunker down. I am recommending that most of my clients invest in one-year certificates of deposit, says Jane M. Young, a financial planner with Pinnacle Financial Concepts in Colorado Springs, Colo. They can move into a longer-term . . . investment in one year if interest rates improve and the yield curve returns to normal.
And if you happen to own a junk-bond fund, sell it. An upside-down yield curve hurts business borrowing, since most corporate debt is tied to short rates. It can presage recession, which takes down junk bonds as well as common stocks.
Munis: Long and strong
A return in the high single digits is something neither the stock- nor the taxable-bond market has delivered within the last year. So municipals are the markets most-attractive option.
Related news and commentary on MSN Money
One of the reasons 30-year Treasury bonds are yielding so little is that demand for them is seemingly inexhaustible, chiefly from foreign central banks. But foreigners are uninterested in municipal bonds, because they dont enjoy the tax benefits and nominal, or face-value, yields are lower than on taxable bonds. The current yield of 30-year municipals, 4.42%, is 0.24 percentage points below the Treasury yield.
On a taxable-equivalent basis, however, that 4.42% is mouthwatering. It is equal to 5.89% for investors in the 25% federal tax bracket, and 6.8% for the top rate of 35%. Even in the 15% bracket, it is equivalent to 5.2%.
Also, whereas investors in taxable bonds are seeking the shortest possible maturity, the norm in the tax-free marketplace is bonds of very long maturities.
Municipal issuance is typically for long-term investments in infrastructure, notes Sheila Amoroso, lead manager of Franklin Federal Tax-Free Income A (FKTIX).
Normally, the longer the maturity, the higher the yield, and that remains true for munis today. It would be true of taxable bonds except that the Federal Reserve has boosted short-term interest rates at each of its 14 most-recent meetings, and seems likely to hike them again, at least once. The market sets long-term rates, and they remain low because of all that foreign buying. That pushes up the price, which is the inverse of its yield.
Investors in high-tax states will benefit from investing in state-only muni funds, whose interest is exempt from state as well as federal income tax. Among national muni funds, Amorosos is one of my favorites, due to the long tenure of its managers (18 years for Amoroso) and consistently outstanding total returns.
| MSN Money Masters: Top national municipal bond funds | | Fund | Yield | 5-year return | | USAA Tax Exempt Long Term (USTEX) | 4.41% | 6.08 | | Franklin Federal Tax-Free Income A (FKTIX) | 4.59% | 5.35 | | Vanguard Insured Long-Term Tax Exempt (VILPX) | 4.56% | 5.33 |
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Notes: As of Jan. 31, 2006. Yield is for most-recent 12 months. Five-year returns are annualized. Sources: MSN Money, Morningstar
Junk lives up to its name
Not on the above list is Eaton Vance National Municipals A (EANAX). I would ordinarily rank it very high, except that it has 17.5% of its assets in below-investment-grade bonds. This is no time to own junk bonds of any variety.
Junk is both overly expensive and extremely sensitive to the business cycle. Yields on junk bonds are typically expressed as a spread over yields on Treasury bonds of similar maturity. Four years ago, the spread was 10 percentage points; now it is 3.75 points.
Moreover, Treasury yields themselves are quite low. The best time to sell high-yield is when yields are low and spreads are tight, and thats the market environment were in today, says Adam Topalian, fixed-income strategist for Lehman Brothers.
Low-rated muni bonds typically are those backed up not by general taxing power, but by the revenues of individual projects, like an industrial park. In a recession, high-yield municipals would suffer more, because those are the kinds of projects more susceptible to economic cycles, says Rafael Costas, co-head of the Franklin municipal bond department.
If youre selling your junk-bond fund, what do you do with the proceeds? If it's a taxable account, put them into municipal funds. Or hold them as cash in a tax-deferred plan like a 401(k) or an IRA. Cash in this sense means CDs, money market funds or Treasury bills.
What to do with fresh money? The same thing, with one possible exception. If you contribute in your 401(k) to an intermediate-term bond fund, the most common type, you arent going to be punished greatly if you simply continue that allocation, rather than switching to cash and then having to switch back again at some point.
Over the long term, these funds are in the bond markets sweet spot, with the best combination of risk and return. Both my wife and I contribute monthly to such funds, and were leaving them untouched.
The greatest risk to bonds right now, in my opinion, is that the new chairman of the Federal Reserve wont be as adroit as the old. Ben Bernanke is possibly more of an inflation hawk than Alan Greenspan was, meaning it will be tempting for him to drag us all into a recession by hiking rates too high for too long.
Cash is the best protection against that, and municipals the least-risky alternative.
At the time of publication Timothy Middleton didnt own any securities mentioned in this article.
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