I am looking for bonds with yields in the 6% to 10% range; in other words, higher than U.S. Treasury yields. At 56, I am retired and cannot afford to lose my money. Should I be thinking about foreign bonds? -- Henry Feinberg
You don't need to look outside the country for reasonably safe bonds with yields in the 6% to 10% range at the moment. And once you better understand the risk of investing in foreign bonds, you may not want to.
Investing in non-dollar-denominated foreign bonds isn't bond investing in a key sense. Bond investing is about receiving fixed payments -- in dollars. If the fixed payments are in a foreign currency, their dollar value will depend on exchange rates. If the dollar is weakening against the currency you're earning, that's great. Your payments will convert into larger and larger dollar amounts. But if the dollar strengthens, your foreign currency payments will buy fewer dollars. Either way, the essential feature of bond investing -- predictability -- is missing.
But as I said, this is a good time to go bond shopping in the good ol' U. S. of A. Yields on many bonds are quite high compared to Treasury yields by historical standards.
There's no free lunch, of course. To obtain a yield higher than a Treasury's you'll have to take on some credit risk, the risk that the bond's issuer will fail to repay. However, at the moment, many bonds that entail only a small amount of credit risk are offering yields much higher than Treasury yields. And you can greatly mitigate credit risk by investing in a mutual fund that buys bonds from a wide array of issuers.
Let's quickly review the bonds vs. bond funds debate. Bonds give you that predictability we discussed above and, if you buy them new and hold them to maturity, the taxes are pretty simple. With bond funds, your dividends will almost certainly fluctuate some as interest rates change and the composition of the portfolio changes, as will your principal.
The less credit risk you plan on taking, the less point there is to buying a bond fund, where some of the income goes to compensate the fund company. Why pay someone to manage a portfolio of triple-A-rated assets for you?
There are three reasons why you might: Maybe you don't have the sums necessary to invest in individual bonds efficiently. To avoid having the broker's commission cut too deeply into your yield, most experts say you need to buy bonds in lots of at least $25,000. If you can't, better to put the money in a bond fund, where the manager can get lower prices for buying in very large lots. Pick a fund with a low annual expense ratio (certainly under 1%, preferably under 0.5%), and it's hard to go wrong. The other reasons you might want a bond fund instead of individual bonds are reinvestment and daily liquidity. Bond fund dividends can be reinvested much more easily than bond coupon payments can, and you can redeem open-end bond fund shares on any business day. Getting out of a bond position, on the other hand, can be anything but cheap and easy.
Beating Treasuries' Yields
I'll review some of your options in a moment. But first, it's worth going over why it's possible at the moment to get much more yield than Treasuries offer without taking on much credit risk.
The prices of long- and intermediate-maturity Treasuries have risen, pushing their yields down, as the supply of the longest-maturity Treasuries has shrunk. That has happened because the federal government, which issues Treasuries to finance budget deficits, no longer has a deficit. It's still issuing some Treasuries in order to maintain a market for its debt, but it's not issuing as many. On top of that, since March the government has been using surplus funds to buy back some of its older bonds from dealers.
This situation is unique to the Treasury market, so Treasury yields have moved down relative to the rest of the bond market. Meanwhile, rising interest rates in the bond market as a whole as the
Fed has hiked the
fed funds rate to slow the economy have pushed non-Treasury yields to some pretty attractive levels, combined with a general aversion to bonds on the part of individual investors over the last two years (according to the
Investment Company Institute
, a staggering $40 billion flowed out of bond mutual funds in 2000 through May).
Finding the Right Funds
You sound like someone who wants to avoid credit risk as much as possible. That means you should steer clear of closed-end bond and income funds and high-yield open-end funds. Here are a few ideas. To pursue any of them through mutual funds, I recommend using
excellent Fund Selector, on its
Municipal bonds: Normally, you would consider municipal bonds only if you were taxed at the highest rate. But the huge rally in Treasuries and the widespread disdain for most other kinds of bonds has lifted municipal yields as high or higher than Treasury yields. And that's without taking into account the fact that municipal bond interest is tax-exempt at the federal level -- and usually at the state level too, if you buy bonds issued in your state. (To calculate the taxable-equivalent yield of a muni bond or bond fund, divide its yield by 1 minus your marginal tax rate.) If you're really nervous about taking on credit risk, high-quality munis are probably the way to go. A municipality can run into economic trouble, but unlike a corporation, it can't evaporate.
Agency bonds and federal mortgage-backed securities: In the taxable realm, bonds issued by Fannie Mae and Freddie Mac , and mortgage-backed securities insured by those entities or by Ginnie Mae, occupy a middle ground between Treasuries and corporate bonds on the credit-quality spectrum, and their yields are substantially higher than Treasury yields at the moment. For more information on these types of securities and funds that invest in them, please see previous Fixed-Income Forums from: Sept. 24, 1999, May 26, 2000, June 2, 2000 and June 9, 2000.
High-quality corporate bonds: If you're willing to take on a bit more credit risk, bonds issued even by top-rated corporations are paying substantially more than Treasuries. The deals aren't quite as sweet as they were back in the spring, when fears of much higher interest rates were peaking. But they're still good.
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TSC Fixed-Income Forum aims to provide general bond information. Under no circumstances does the information in this column represent a recommendation to buy or sell bonds, funds or other securities.