U.S. bonds start to look interesting again



Bond investors sacrificed little by lying low in money market funds or one-year CDs during the last year, while waiting for Federal Reserve interest-rate maneuvering to run its course.

They could plop money into a money market fund yielding 4.5 percent and retain the freedom to bolt into something more promising if it came along. Meanwhile, 10-year Treasury bonds provided none of that flexibility and paid investors nothing extra for tying money up for years. From 2003 to 2005, yields rose to 4.4 percent from 3.1 percent.

But recently, as 10-year Treasury yields have edged slightly over 5 percent, some money managers have been venturing into territory they have previously considered too risky in a rising rate environment. They are slowly moving some money out of very short-term investments and into intermediate-term bonds, or bonds maturing in about four to 10 years.

At Mesirow Financial in Chicago, for example, fixed-income managing director Mark E. Newlin has begun to move some money out of both short-term bonds and very long-term bonds, and invest in bonds maturing in five to seven years. His thinking: "It will be the best bang for the buck" if inflation continues, or if the Fed's interest rate increases ultimately slow the economy too much.

Although analysts are not expecting a serious slowdown, the potential always exists when the Fed is trying to cool the economy. And if the economy heads into a rough patch, the Fed might do an about-face and start lowering interest rates. If that happens, investors holding Treasuries yielding 5 percent will probably be getting paid well compared with the rates that would be available.

Still, as Newlin moves into intermediate bonds to lock in those yields, he's treading carefully - avoiding corporate issues and buying relatively safe bonds such as Ginnie Mae-backed commercial mortgage bonds with top-rated AAA ratings.

Thomas H. Atteberry, co-manager of the FPA New Income Fund Inc., sees a 5 percent Treasury yield as a reason to venture cautiously into intermediate bonds. Still, his most recent major purchase was an inflation-protected U.S. government bond maturing in 2007.

If inflation does flare and interest rates continue to rise, investors in intermediate bonds could lose money.

It happened last quarter, as the yield on the 10-year Treasury climbed from 4.4 percent at the end of 2005 to 4.88 percent.

Ten-year Treasury bonds dropped about 2.6 percent in value, and investors in U.S. Treasury mutual funds lost 2.20 percent in the last quarter, according to Lipper Inc.

Losses in government bond funds are startling for investors, because they assume U.S. Treasury bonds are safe. But no bond is immune from losses when interest rates are climbing. Consider this: If you had a government bond yielding 4 percent, but could get a new bond that yields 5 percent, which would you want? Of course, you'd want the extra 1 percent of interest, so your old 4 percent bond would slip in value.

The drop wouldn't matter if you held onto your bond. You'd continue to collect your 4 percent interest until the bond matured. But if you wanted to sell it, you would lose money.

And if you had a bond fund, you would lose money because it would be full of bonds paying relatively low interest at a time when better yields are available. This is true even with inflation-protected bond funds. The average inflation-protected bond fund lost 2.14 percent last quarter, according to Lipper.


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