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The best bond deals
As interest rates climb, these are the investments to consider.
December 20, 2005: 10:29 AM EST
Julia Boorstin, FORTUNE writer-reporter

NEW YORK (FORTUNE) - The Fed's 13 interest-rate hikes over the past year and a half have made borrowing more expensive -- but they haven't done much for savers.

Yes, you can get better deals -- the average five-year CD, for example, now yields 3.9%, according to BankRate.com, up from 2.9% back in March 2004, a few months before the Fed hikes began. But if you're in the 28% federal tax bracket, that only nets you 2.8%, which is far less than the recent inflation rate of 3.8%.

Key TIPS for savers

So the best deals for savers are those that help beat taxes or inflation—or both. Inflation-indexed securities, known as TIPS, pay a fixed interest rate but have their principal adjusted to keep pace with the consumer price index.

Recently five-year TIPS were yielding about two percentage points above inflation on a five-year bond. Though locking in just a 1% or 2% after-inflation yield may sound less than thrilling, TIPS are a smart way to safeguard a portion of a portfolio.

Outsmarting inflation

"Even if inflation is just 3%, the return translates to over 5%, which doesn't sound bad at all," says Tom Atteberry, co-portfolio manager of the FPA New Income fund.

A good choice: Vanguard Inflation-Protected Securities Fund (Research), which has a 0.17% expense ratio and an 8.5% five-year average annual return. One note: When your TIPS increase in value because of an inflation adjustment, that gain is considered reportable income, even though you don't receive it until the bonds mature. So TIPS are best held in a tax-deferred account.

Municipal bonds make sense

Nothing beats the taxman like municipal bonds. And in early December munis were actually paying more than comparable Treasuries, even without the tax advantage: The average AA municipal bond yield was 4.57%, vs. 4.48% for the ten-year Treasury (or 3.23% for someone in the 28% federal tax bracket), according to Moody's.

In part, that's because of worries about state and local government finances, says Mark Zandi of Moody's Economy.com.

But those finances have been improving lately, and in any case, muni bonds rarely go into default. For residents of high-tax states like California, New York, or Massachusetts, state-specific muni bonds or funds increase the advantage.

Diversified bond funds, with their ability to hunt for the best opportunities in various markets around the globe, aim for a combination of income and capital gains.

Bill Gross's PIMCO Total Return (Research), an $89 billion no-load fund that charges a 0.43% expense ratio, has had a 7% average annual return for the past five years; it recently yielded 4.4%. Vanguard, Loomis Sayles, and most fund companies offer no-load diversified bond funds.

Nonbond alternatives

Given the low yields generally available in the bond markets, income investors may want to consider a nonbond alternative: dividend-paying stocks.

True, stocks are generally riskier than bonds. But dividends offer a couple of advantages: In most cases, they are taxed at only 15%—and unlike bond payments, they can rise over time, helping you outpace inflation. A number of the stocks recommended here offer yields above 3.5%.

Finally, for your emergency fund or other cash that you want to keep at the ready, you can go to BankRate.com to search out the highest-yielding shorter-term CDs and money market funds around the country. For example, HSBC (Research), Western Financial Bank, and Emigrant Direct all offer accounts that pay 4% or more and have no minimum deposit.

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See 10 rock-solid stocks here.

See 7 star funds here.

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