Today's Bonds: A Double-Digit Delicacy

Bonds aren't the most exciting investing item, but they're better than you think.
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A well-diversified retirement portfolio doesn't just include a blend of different-sized companies as well as growth and value plays. How about adding some bonds?

Bonds?, you might be asking. Jubak's kidding, right? Nope. Get over your prejudices. Tune up your palate. Stop thinking about bonds just as a way to keep your money safe when you're near retirement or waiting for the stock market to settle down.

In the current market, bonds -- specifically corporate bonds -- offer a chance to make a solid profit if the economy shows signs of even a modest recovery. They also give you solid protection and may provide a little profit if the now-anticipated recovery takes longer to arrive than expected. In short, corporate bonds combine very low risk with reasonably high reward -- and that deserves a look right now.

Bonds: Medicine or Tonic?

To many investors, bonds are like a bad-tasting medicine. We know they're good for us -- or at least for our portfolios -- but yuck, they're just so tough to swallow. So we put off taking the medicine as long as we can, hoping that maybe we can squeak through until it's time for equities again. And it's only when the disease is impossible to ignore that, in a panic, we decide to drink not a sensible dose but the whole bottle.

That's why investors tend to avoid bonds until they're so frightened of stocks that anything besides equities looks good. In September, $8 billion flowed into taxable bond funds, according to the Investment Company Institute, about 20% above the monthly average for 2001. That's understandable in the aftermath of the terrorist attacks. The cash flow was even higher in August, however, at $14 billion. And through September, according to the Investment Company Institute, $60 billion has flowed into taxable bond funds this year. That's about even with the $56 billion that flowed out of stock mutual funds in September, August and March -- the three worst months this year for stock fund cash flows.

And bond yields sure don't look mouth-watering right now either. The 10-year Treasury, the market benchmark now that the U.S. Treasury has announced it will stop selling the 30-year bond, yielded just 4.2% on Nov. 7. The five-year note -- an even slimmer 3.5%. And the two-year flavor, a paltry 2.3%. Yep, just let me load up my retirement portfolio with that 2.5% yield.

So why think about bonds at all? Well, because bonds offer more than just a yield.

First, they offer greater safety than stocks, and safety, as investors who have suffered through the bear market of the last 19 months know all too well, has value. The value of that safety, always hard to quantify, increases as investors get closer to the period when they need to start drawing down on the value of a long-term portfolio to actually pay for retirement, a home or college tuition.

Two Ways to Profit

Second, investors don't just make money on bonds by collecting interest. Investors also have the potential to make a profit from any appreciation in the price of a bond. Bonds are less volatile than stocks but they do move in price. Catching a bond trend can net an investor a very nice profit indeed. The Vanguard Long-Term Bond Index has returned almost 15% in a year when yields have marched steadily downward.

Bond prices move up for two very different reasons. First, bond prices rise when interest rates fall. That's not as perverse as it sounds. Think of it this way: If interest rates fall so that all newly issued two-year notes pay just 2.4%, all existing two-year notes paying 2.5% become more valuable. They would in fact rise in price until the price climbed high enough to make interest payments from the note equal to just 2.4% of its market price.

And second, bond prices can climb when the credit quality of the bond issuer improves. That's a fancy way to say that bond prices go up when the risk that the company or government that has issued the bond will stop making interest payments on schedule, or even go belly-up, has diminished.

Why should an improvement in credit quality turn into a higher price? Let's say a risk-free bond (for all intents and purposes, U.S. Treasury bonds are risk-free because the U.S. government is unlikely to go bust) pays 5%. How high an interest rate would you demand before you'd buy the bonds of a company with a good chance of going bankrupt? Well, the current market says that a yield of 70% is about right if you're

Weirton Steel

(WRTL)

and restructuring to stave off bankruptcy.

Now imagine that Weirton pulls a rabbit out of its hat and manages to cut costs, increase efficiencies and find more profitable markets for its products so that bankruptcy is no longer a probability. Then maybe investors would demand only, say, 10% interest -- about what they're currently demanding for

Lucent

(LU)

bonds. A bond with a market price of $100 and paying $70 in interest each year (a yield of 70%) would have to climb in price to $700 for that same $70 in annual interest to be equal to a yield of 10%. Not a bad return on a bondholder's investment.

It's the combination of those two reasons for potential price appreciation that makes corporate bonds attractive right now.

There's Still Time to Win

It's certainly true that you've missed most of the price appreciation that bond owners can expect from falling interest rates. But the

Federal Reserve

isn't done cutting rates, even after Tuesday's action. The economy is weak enough that the Federal Reserve will have to cut the federal funds rate to 1% next year, many Wall Street economists believe.

That's not huge when you think about the aggregate drop in interest rates since the Federal Reserve began its move to lower rates in January 2001, when the federal funds rate stood at 6.5%. But it's still enough to send bond prices higher. How much higher depends on a complex calculus that balances interest rate cuts now against the possibility of future inflation. My estimate -- if the economy stays weak enough so that inflation isn't a big worry -- would be that we could see the yield on the 10-year Treasury bond fall to 4% from the current 4.2%. That drop would produce price appreciation of about 6%.

Not bad, but owners of corporate bonds might do even better. They'd see the price of their bonds appreciate with any drop in interest rates, of course, but they also stand to benefit from an overall improvement in credit quality if the economy improves next year.

Corporate bonds at companies with moderately shaky financials currently pay a heavy premium for the risky state of the economy. For example, on Oct. 22

Ford

(F) - Get Report

sold 10-year bonds at a yield of 7.304%, 2.7 percentage points above the then-yield on 10-year Treasuries. The financial arm of

General Motors

(GM) - Get Report

, GMAC, sold 10-year bonds on Oct. 26 with a yield of 7.364%, 2.82 percentage points above 10-year Treasuries. Both companies are rated BBB-plus, the third-lowest investment grade for bonds, by Standard & Poor's. (Contrast this to the 3.63% yield that AAA-rated

Pfizer

(PFE) - Get Report

recently paid on an issue of three-year notes.)

Yawning Yield Gap

The size of that yield gap -- called the spread -- between BBB-plus securities and comparable Treasuries is extremely large by historical standards. In the last 20 years, the spread between BBB corporate bonds and Treasuries has exceeded 2.5 percentage points only three times: in 1980-82, in 1987 and now. That spread almost fully discounts investors' concerns about the economy. Moreover, the spread will begin to narrow as an economic recovery starts to seem likely. Investment-grade corporate bonds have returned 11% -- including interest payments -- over the last year, underperforming Treasuries as investors paid up for safety. That's likely to reverse, with corporates outperforming Treasuries as the economy recovers.

Estimating the return on corporate bonds over the next year is tricky. If the economy looks likely to recover -- but the recovery doesn't threaten renewed inflation -- investors could easily see 12% from corporates over the next 12 months in interest payments and price appreciation. If the economic recovery starts to look less likely, that return will be lower because price gains could well turn to losses as the spread between corporate and Treasury issues expands to 3 percentage points. Even in that situation, though, the current high yields on corporate bonds provide substantial margin for error because they're high enough to more than balance out modest drops in bond prices.

The only real danger to investors in these bonds would be a much stronger than projected economic recovery, one strong enough to get the Federal Reserve to stop cutting interest rates and start raising them. In my opinion, that's unlikely in 2002.

Double-Digit Returns

That's why corporate bonds, especially low investment-grade issues such as Ford and General Motors, are so attractive right now. If the economy recovers as everyone now expects, they'll provide a double-digit return. If the recovery is delayed, current high yields should more than balance out price declines. The combination is likely to offer somewhat lower gains than stocks, if everything works out as projected, but much less risk than equities as well.

Most investors are better off using a mutual fund to buy bonds. If you buy corporate bonds individually, commission costs and price spreads can easily wipe out any profit you might make. My recommendation: Use a low-cost, no-sales-commission bond fund to add corporate bonds to your long-term portfolio. Vanguard offers two good funds:

(VBIIX) - Get Report

Vanguard Intermediate-Term Corporate Bond and

(VBLTX) - Get Report

Vanguard Long-Term Corporate Bond. Also take a look at

(FSIBX)

Fidelity Spartan Investment Grade Bond and

(DODIX) - Get Report

Dodge & Cox Income.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: ICOS.