NEW YORK (Money Magazine) -
After three years of watching stocks fall, investors have been flocking to the safety and security of bonds. So far, that's paid off: For the past 12 months, the average bond fund is up 3.3 percent while the average stock fund has declined 13.2 percent.
It's unlikely that bonds will outperform stocks for much longer. After two years in which the Fed lowered interest rates, the federal funds rate sits at 1.25 percent, the lowest it's been in 41 years. While there's a slim chance that it could fall further, it's far more likely that interest rates will go up. If that happens, existing bond prices -- and their returns -- will drop. So in 2003, stick to the following fixed-income investments.
| Special: Investing in 2003
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Munis. If you're in a high tax bracket, consider municipal bonds. Because of the tax advantage municipal bonds offer investors, their yields are typically 80 percent of Treasury bond payouts. Today that ratio is 85 percent, making municipals an attractive alternative to Treasurys (and that's before you add in the federal tax savings).
Two-year munis pay 1.8 percent, the equivalent of a 2.6 percent taxable yield for investors in a 31 percent bracket. (Buy your home state's munis and you'll avoid paying local taxes too.) We like the Vanguard Intermediate-Term Tax-Exempt fund. It has an expense ratio of 0.19 percent versus the average municipal bond fund's 0.8 percent fee.
Corporates. Corporate bonds tend to do well coming out of a downturn because fundamentals improve. Even if you don't buy the recovery theory, here's a value argument: The difference, or spread, between yields of the average investment-grade bond and those of the average Treasury is 180 basis points, which is wider than it's been in the past decade. We recommend sticking to a fund like the FPA New Income fund. It has an expense ratio of just 0.58 percent and one of the finest 10-year records.
High-yield. If you're looking for more income and are willing to take on additional risk, invest in high-yield bonds. Also known as junk bonds, high-yields (corporate bonds rated BB or below) are riskier than their higher-rated corporate brethren and thus pay higher yields.
Junk bonds tend to do well in a recovery, and their prices aren't as sensitive to interest-rate hikes. They're yielding about nine percentage points more than the average Treasury and offer the potential for capital appreciation if the debt is upgraded.
We suggest a well-run fund like Northeast Investors that spreads its bets among many industries and has an expense ratio of 0.65 percent, plus one of the best returns over the past 10 years. Lastly, don't overlook inflation-protected bonds (TIPs), which are guaranteed by the U.S. government and offer semiannual payments that rise along with the rate of inflation. You can buy them through your broker or the Treasury Direct program. Several fund families offer TIPs, including American Century and Vanguard.
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