Bonds Primer: Choosing a Bond Fund, Part 1

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With any investment, you want to be aware of how expensive or cheap it is by historical standards, and the same goes for bonds.

With stocks, the price-to-earnings ratio is the leading valuation measure. With bonds, it's yield. (We explained yield in an earlier

piece.)

If you're considering buying risk-free Treasury bonds, you want to look at how today's yields compare with the historical averages. If you're considering any other class of bonds, you want to look at how its yields compare with Treasury yields, and then look at that measure, called the

spread

, in historical context.

Treasuries are Expensive Historically

Let's start with Treasuries. The chart below shows that Treasuries of all maturities (or at least the three we selected to represent the short-, intermediate- and long-term sectors) are now extremely expensive by historical standards. The longest Treasury security, the 30-year bond, is yielding around 5.10%, close to the lowest it's ever yielded since the Treasury started regularly issuing the bond in 1977.

Bottom line: Long-term T-bonds are not very attractive right now, so if you're going to buy Treasuries, it makes sense to buy relatively short maturities. If rates rise, you (or your fund manager) don't have to wait as long to reinvest at higher yields.

There's some basic economic theory implicit in this strategy. When interest rates and bond yields are falling, the expectation is that the economy will eventually slow (keeping inflation low) and that as it does, bonds will outperform stocks. When investors think this trend is in an advanced stage (when they think yields aren't going to go much lower), they want to own short-term bonds so as not to get hurt when the trend reverses.

Likewise, when rates and yields are rising, the expectation is that growth will accelerate (causing higher inflation) and stocks will outperform once again. When investors think this trend is in an advanced stage, they want long-term bonds to benefit from its reversal.

As with using any valuation measure, comparing current yields with historical averages won't necessarily render accurate buy and sell signals. Just because yields are very low by historical standards doesn't mean they aren't headed lower.

But knowing a bit of interest-rate history will at least give you an appreciation of the relative value of the bonds or bond fund shares you're buying and might help you decide whether to speed up or slow down your fixed-income purchases.

How Spreads Work

With other types of bonds -- investment-grade corporate, high-yield, foreign and municipal -- the yields themselves matter less than how the yields compare with Treasury yields. That's because when you buy a class of bonds other than Treasury bonds, you're taking on credit risk. What matters is how much you are being compensated to take that risk. (Please see our earlier

discussion of credit risk.)

Consider: Corporate bond yields might be very high, but if the yields aren't much higher than Treasury yields, it doesn't make a lot of sense to take on the credit risk. Likewise, corporate yields might be low, but if they're a lot higher than Treasury yields, you might think twice about buying the Treasuries.

The difference in yield between any credit-risk-carrying fixed-income category and Treasuries is called a spread, as in: "High-yield spreads are double their historical average."

That sentence means the difference in yield between a representative junk bond (or junk bond index) and a Treasury of comparable maturity is twice as big as it has been historically. And that's exactly how bond market analysts use spreads; they compare them with their historical averages. The wider the spread, the more value there is in the risky product.

Here, too, some basic economic theory applies. If spreads are narrowing because corporate credit quality is improving, the expectation is that it will stop improving at some point, and spreads will widen out again. Generally, spreads narrow as Treasury yields rise. When the narrowing trend is in an advanced stage, investors want to own Treasuries (on the theory that corporate or junk bonds will lose value as the spread widens).

Likewise, if spreads have widened because corporate credit quality has deteriorated, investors want to buy credit risk in anticipation that the trend will reverse. Spreads generally widen as Treasury yields drop.

As you can see from the chart below, all taxable risk products are very cheap -- spreads are wide -- by historical standards as of this writing. (So are muni bonds, but as we'll explain shortly, the standard valuation measure is slightly different.)

Let's start with investment-grade corporate bonds. As of last Friday, the

Merrill Lynch U.S. Corporate Master Index's

yield was 164 basis points (1.64 percentage points) higher than the 10-year Treasury note's. Over the previous 10 years, the spread has ranged from 64 to 154 basis points, averaging 98. Last year, the spread averaged 73 basis points.

High-yield bonds are also cheap. The spread of the

Merrill Lynch High Yield U.S. Corporate Index

to the 10-year note, 604 basis points as of last Friday, averaged 451 from 1987 to 1997, ranging from 268 to 974 over that period. Last year, it averaged 283.

And emerging-market bonds? Forget about it. More volatile even than high-yield bonds, their spreads have fluctuated in a much wider range over a much shorter period. That makes it more dicey to rely on yield ratios for a sense of the market's limits. But for the curious, the leading measure of emerging market yields, the "sovereign spread" on the

J.P. Morgan Emerging Market Bond Index

, 1,103 basis points as of last Friday, ranged from 330 to 1,924 from 1991 to 1997, averaging 764. Last year it averaged 445.

Measuring Muni Bonds

Municipal bonds have a different valuation measure. In an earlier

piece, we explained how you can calculate whether munis make sense for you. If they do, you should also consider whether they are cheap or expensive by historical standards. If they're cheap, maybe you want to buy more.

Investors evaluate munis by determining their yields as a percentage of the prevailing taxable yield. The muni yield is divided by the taxable yield to calculate a ratio. For example, if the yield of a muni bond index is 4.50% and the comparable Treasury yield is 5%, the ratio is 90%. The higher the ratio, the better value munis represent.

Like corporate and high-yield bonds, munis are now cheaper on a relative basis than they've been in years. As the chart below shows, the "yield to worst" of the

Merrill Lynch Municipal Master Index

over the 10-year Treasury -- 102% as of last Friday -- compares with an average of 88% from 1992 to 1997. (Because most munis can be called by the issuer 10 years after they're issued -- you get your money back and the issuer stops paying interest -- the important yield measure isn't yield to maturity but yield to the earliest possible call date, i.e. yield to worst.)

As with the absolute levels of Treasury yields, spreads and ratios don't necessarily scream buy or sell. Just because a spread or ratio is higher than its historical average doesn't mean it won't go higher still as the asset class continues to underperform Treasuries.

But knowing the history may help you decide whether to step up or slow down your fixed-income purchases -- particularly if the width of spreads doesn't seem justified to you, based on your economic outlook.