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Bond Investors Find Themselves Walking Tightrope

Decent yields are still available on some categories of bond mutual funds--if you can handle the risk involved.

October 20, 1998|PAUL J. LIM

These are confusing times for income-oriented investors.

With the Federal Reserve Board cutting short-term interest rates, yields on Treasury bills and other short-term securities are tumbling--forcing many investors in those securities to think about alternatives.

But what the Fed's new stance will mean for longer-term bond yields, and thus whether this is a good or bad time to lock in those yields, is still unclear.

If the Fed succeeds in staving off an economic recession, then current yields on corporate junk bonds and emerging-market debt--which have soared in recent months as investors have shunned risk--might look like great deals a few months from now.

But if the Fed is too late and investors perceive more economic trouble ahead, they could force the yields on higher-risk bonds that much higher, while driving "safe" Treasury bond yields even lower.

As with any investment decision, the income decision now depends on how much risk you're willing to take in exchange for the yield you want, financial planners say.

The good news is that income-oriented investors who want to take advantage of higher yields on out-of-favor bonds have a lower-risk option than buying individual securities: bond mutual funds.

Bond funds spread risk over an entire portfolio of holdings--for instance, if one junk bond in a high-yield portfolio busts, its effect is offset by the majority of others that continue making payments.

"Higher-income areas, like the mortgage, high-yield and emerging-market [debt] market are typically those that require high-risk tolerance and are areas where professional management and diversification can be a great benefit," said Alice Lowenstein, fixed-income editor for Morningstar Mutual Funds.

To be sure, individual bonds have been popular among many income-oriented investors for a variety of reasons. If individual bonds are purchased at or below par (their redemption value), they guarantee a return of principal if held to maturity. Plus, they deliver a set payout.

With a fund, there are no such guarantees. For instance, if you were to invest today in a long-term government bond fund, there's a good chance you'd be buying into a portfolio of bonds valued well above redemption value. The manager, in an effort to seek yield or safety, might have paid $1,100 for a bond that promises to return only $1,000 once it matures.

Theoretically, this means that these bonds, once they mature, would guarantee a loss to the portfolio. In reality, though, most fund managers wouldn't hang on to such bonds until maturity. And investors would see some compensation through the income earned.

Nevertheless, bond fund investors aren't assured that their original principal invested won't incur losses--especially if market interest rates should rise, depressing the value of lower-yielding bonds in a fund portfolio. (See sidebar.)

Still, the trade-off is the diffusion of risk: A bond fund portfolio can generate decent yields while protecting you against the extreme loss of principal that can occur if you own an individual bond that defaults.

Where to find those decent fund yields today? Here are some ideas:

Municipal Bond Funds

Normally, a tax-free municipal bond is considered a good deal when its yield is 85% that of Treasuries, notes Alexandra Lebenthal, president and chief executive of Lebenthal & Co. in New York, one of the leading sellers of muni bonds to retail investors.

Yet, in the last couple of months, yields on high-quality, insured, long-term municipal bonds have risen to more than 95% that of similar-maturity Treasuries.

Because income paid on munis is exempt from federal taxes, a muni yielding 4.85% is the equivalent of an 8% yield on a Treasury bond for a person in the top 39.6% federal income tax bracket.

But Duke Johnson, president of the La Jolla Institute for Wealth Management in La Jolla, stresses the need to find good-quality, low-cost muni funds.

For California investors, he recommends the Vanguard California Tax-Free Intermediate-Term bond fund (no-load; minimum initial investment: $3,000).

The average credit quality of bonds in this $895-million portfolio is AAA, the highest possible. And the average annual expenses for this fund are a low 0.18% of assets. That's 83% less than that of the typical muni bond fund. Plus, because this fund invests only in bonds issued by California municipalities, income derived from it is exempt from both federal and state taxes.

With a 4.46% 12-month yield, that's the equivalent of an 8.7% yield on a Treasury for state residents in the combined 48.9% state and federal tax bracket.

Johnson also likes USAA California Bond Fund (no-load; minimum initial investment: $3,000).

This $533-million single-state fund has recently yielded slightly more than Vanguard's fund--about 5.2%. The tax-equivalent yield would be about 10.1% for someone in the 48.9% state and federal tax brackets.

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