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Bonds an attractive option, but beware of risks

Updated: May 3, 2013 12:14PM



Originally posted: August 7, 2001

If you’re feeling pretty smug about the fact that you took some money off the stock market table in time to avoid recent market losses, think again. If you put that cash in a money market type account, your principal is safe - but your returns are dwindling.

Now that the Federal Reserve officially has cut its short-term interest rate targets, yields are dropping on certificates of deposit, money market mutual funds and Treasury bills.

For example, 90-day T-bill rates have been below 5 percent, and even the highest yielding government-only money market fund yields dropped toward the 5 percent level. (These short-term money market fund yields may be slightly higher than other offerings, but as their investments mature in the next month, they’ll be replaced with new, lower-yielding securities.) Average yields on six-month bank CDs also have dropped.

You can get higher yields by purchasing longer-maturity debt or by buying bonds with lower quality ratings - but the most dangerous thing a ``chicken money’’ investor can do is chase higher yields by taking on more risk. After all, there’s just as much potential risk in buying lower-quality bonds as there is in the stock market. In fact, as corporate earnings projections decline, there may even be more potential risk in buying the debt of companies that may have trouble maintaining their interest payments.

And here’s another warning: When looking at alternative investments for your ``chicken money,’’ don’t be taken in by announcements of higher ``total returns.’’

Total returns may look attractive, but that figure is composed of two ingredients: current yield and rising bond prices. The current yield is the promised interest rate coupon payment on a debt security. That should provide a steady stream of income. But the price of a bond can fluctuate wildly.

As interest rates decline, those older, higher-yielding bonds become more attractive. An older, high-quality bond with a 7 percent interest rate may have cost the original purchaser $1,000. But today, you’d have to pay more for that bond. Those rising bond prices are considered a part of the ``total return’’ to the investor. But, of course, if interest rates were to move higher, the bond price would fall. That applies to all bonds - and all bond funds. Since interest rates have been falling much of the last year, the total return figures look attractive right now. But that’s not guaranteed to continue - and it shouldn’t be the only basis for considering a purchase.

Conservative alternatives

So what can a conservative investor do these days? Here are a few alternatives.

There are some segments of the bond market that have become relatively attractive. One reason that interest rates have been falling (and bond prices have been rising) is that foreign investors have rushed to buy our U.S. government guaranteed Treasury securities, considered the safe haven for the rest of the world. But those same foreign investors have overlooked the tax-free municipal bonds of cities, states and local governments. (Those tax-free bonds carry lower interest rates, reflecting the fact that investors pay no federal income tax on the interest they earn.) After all, foreign investors have no need for tax-free income since they don’t pay U.S.

income taxes.

The fact that foreigners have overlooked these tax-free municipal bonds has kept their prices relatively low - and their yields relatively high - compared with Treasury securities.

Before you rush out to buy tax-free municipal bonds, though, you should carefully examine the quality of the bonds and the equivalent after-tax yield you’ll receive compared with a taxable investment of the same quality. And instead of buying individual municipal bonds, whose prices may be difficult to track, consider municipal bond funds that buy a variety of bonds in large enough quantities to get the best trading price. And you certainly won’t want to buy tax-free bonds in a retirement account - where you don’t pay taxes anyway.

Here’s an example of what you might be looking at if you checked on municipal bond funds today.

U.S. Global Investors (800-US-FUNDS) offers two municipal bond funds. The U.S. Global Tax-Free fund holds bonds with an average maturity of about 9.4 years. All are rated A or better (either AA or AAA). The current yield is 4.29 percent. At first, that might not look too attractive. But if you’re in the 31 percent tax bracket, that’s equivalent to a 6.22 percent yield on a taxable bond. And if you’re in the 36 percent tax bracket, it’s equivalent to 6.70 percent.

Long-term maturities

Although you could sell your shares in this tax-free bond fund at any time, you might be concerned about buying a fund that owns bonds with such relatively long-term maturities. The same company offers its U.S. Global Near-Term Tax-Free Fund, with an average maturity of 4.3 years for its investments - all A-rated or better. As you might expect, the yield is slightly lower - 3.79 percent now. But if you’re in the 31 percent tax bracket, that’s equivalent to earning 5.49 percent on a taxable bond. If you’re in the 36 percent bracket, you’d need to earn 5.92 percent to match that yield.

If you live in a high-tax state, you’ll even find funds geared to purchase bonds only from that state that will be exempt from state taxes as well as federal taxes. And you can get higher yields by purchasing bonds - or bond funds - that buy slightly lower credit quality bonds. For instance, the Strong Short-Term Municipal Bond Fund (800-368-3863) has 59 percent of its bonds rated BBB or lower (and the balance A rated or better). The average maturity is shorter than the funds mentioned above - only 2.8 years, and the current yield is 4.16 percent. So you take less time risk, but slightly more credit risk, for about the same return.

Municipal bond funds aren’t for everybody, and certainly they aren’t for all of your money. And municipal bonds aren’t the only alternative for those seeking slightly higher yields with safety. Now that people are paying attention to safety, you’ll be seeing more ads from banks promoting slightly higher rates on their CDs.

So it’s worth looking at alternatives, but never forget that the first objective of investing ``chicken money’’ is preservation of capital. Be sure you understand any additional risk that might go along with higher yields you find in your search.

Clarification

There is no minimum investment required to use the T. Rowe Price Rollover Investment Service featured in last week’s column. But there is a one-time fee of $100, which is refunded if you invest your rollover account in T. Rowe Price mutual funds. For more information, phone (800) 844-9294.

Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Pennzoil Co. E-mail: savage@suntimes.com. Her second book, published by HarperCollins, is Terry Savage’s New Money Strategies for the ‘90s. Copyright Terry Savage Productions.



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