Bonds: Unexciting but safer

Investments: The fixed-income route may not be glamorous, but ways can be found to maximize returns.

Dollars & Sense

October 28, 2001|By Lorraine Mirabella | Lorraine Mirabella,SUN STAFF

As short-term interest rates have plunged, conservative investors have felt the pinch, watching yields drop steadily on their certificates of deposit and money market accounts.

But fixed-income investors can still pursue strategies to maximize returns, depending upon the type of investment and the level of risk, even as the Federal Reserve slashes interest rates to stimulate a faltering economy.

"Anytime there's global uncertainty and chaos in the markets like now, the difference between interest rates on government fixed-interest [securities] and corporate bonds gets wider," said Christopher P. Parr, a vice president and principal with Financial Advantage Inc. in Columbia.

"We're seeing some attractive opportunities ... on some high quality corporate bonds" issued mainly by blue chip, as opposed to speculative, companies.

"I wouldn't expect them to outperform stocks, but over the next few years, fixed-income investments like bonds ... may provide reasonably competitive returns with a lot less risk," he said.

Boosting returns should not be the sole consideration with fixed-income investments such as bonds, bank certificates of deposit, money-market mutual funds and bank money-market accounts.

Investments that promise higher returns carry higher risk. Investors need to consider how and when they plan to use the funds because some fixed investments penalize investors who withdraw funds early.

Bonds, essentially loans that investors make to bond issuers, include Treasury bonds, corporate bonds, high-yielding "junk" bonds and tax-free municipal bonds. Bonds carry different terms of maturity - the date on which the bond issuer repays the principal. In the meantime, investors get interest, usually twice a year, called the coupon rate or yield.

But people often fail to realize that bonds are marketable securities that can be sold at any time, said J. Michael Martin, president and principal and founder of Financial Advantage.

A bond's value fluctuates. "It might be a $10,000 bond on the face of it, but on any given day it's worth more or less, and it could go either way," depending on interest rates, Martin said.

If the price of a bond goes down, its interest rate rises. If the price goes up, the rate falls.

"Bonds have a purpose other than just earning fixed income. You can own them for the purpose of price appreciation," he said.

The change in interest affects only the bond's trading value, not the yield it pays. It's important to have bonds with different dates of maturity, to protect against falling rates, Martin said. A short-term bond usually means one to three years, while medium is three to 10 years and long-term is 10 to 30 years.

Bond investors also need to consider credit risk. Government-backed U.S. Treasury bonds are the safest. In September 1998, the Treasury introduced inflation-proof bonds, or Series I Bonds, which can be purchased in minimum denominations of $50 and guarantee a rate above inflation.

"You're guaranteed a real rate of return over and above inflation," said Rick Greiner, area manager for Maryland in the Treasury's Bureau of Public Debt. "If someone is interested in risk-averse investments, the I bond is a good product for that because of its rate structure."

The EE bonds are now paying 4.5 percent, while the I-bond is paying 5.92 percent, which includes a fixed rate of 3 percent plus the inflation adjustment. The variable rates are adjusted twice a year and will change Nov. 1. Earnings from the bonds are not subject to state and local taxes, but federal tax will be due when the bonds are redeemed.

In the current climate of falling interest rates, the I-bonds are viewed as a good bet for retirees or investors approaching retirement who do not depend upon the interest payments but on the proceeds at maturity, said Greg McBride, a financial analyst with Bankrate.com, a consumer financial Web site.

"After inflation, the [fixed] rate of return exceeds what you will find with CDs currently and has some tax advantages," McBride said.

Tax-free bonds, or municipal bonds, are issued by cities and states. The trade-off is that they pay lower interest rates.

"If it's not a U.S. government security, you're taking on credit risk," said Victoria Schwatka at Legg Mason Trust in Baltimore.

Corporate bonds carry the risk that the company that issued the bond might default. High-yield "junk bonds" - which pay higher interest because the issuer is less credit-worthy - are too risky for most individuals, Schwatka said.

"The fixed-income markets, unlike the equity markets, are really geared toward the mega-high net worth or institutional investor," Schwatka said.

"If you have $100,000, that's not a lot of money in the fixed-income market. For investors with smaller amounts of money, we recommend [bond] mutual funds that have guidelines that accommodate a client's tolerance for risk."

Buying a bond mutual fund that owns hundreds of different bonds allows investors to diversify their bond investments.

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