Fixed income: 4 safer bets for today's market

@Money June 6, 2012: 9:28 AM ET

(Money magazine) -- This is the third part of Money magazine's series on How to make your money safer.

The fixed-income market is a traditional safe haven that's grown risky in its own right.

Here's how to put together the right mix of fixed-income assets for your portfolio.

Pick up high-quality munis, not Treasuries

U.S. Treasuries have long been the shelter of choice for safety seekers, and it's easy to see why: In 2008 intermediate-term government bonds gained 18% while stocks sank.

Looking ahead, there's a big risk looming. No, Uncle Sam isn't going to default on his debts, plentiful though they may be.

Rather, the frenzied demand for Treasuries has pushed yields so low -- 10-years are paying a scant 1.98% -- that interest rates have nowhere to go but up. As they start to climb, the price of your older bonds will sink, and you could lose money on Treasuries.

Today's safer "safe" fixed-income bet: tax-free municipal bonds issued by states, counties, and cities.

True, some analysts have also been decrying the health of municipal government coffers. And, yes, there have been a handful of headline-grabbing defaults -- most recently Stockton, Calif.

But the overall muni default rate last year was 0.0002%, according to Moody's.

"Municipalities are going in the right direction," says Philip Condon, DWS Investments' chief fixed-income strategist.

At the same time, you're being paid to assume that small risk. The highest-quality 10-year munis pay about 2% now, according to Municipal Market Advisors. That's slightly more than Treasuries, even though munis historically pay 15% to 20% less. And since munis are exempt from federal taxes, that's really like earning 2.8% on a Treasury if you're in the 28% bracket.

You can build in even more margin for safety:

If you're going with individual bonds, demand the highest quality. Start with triple-A credits, says Kevin Giddis, head of fixed income at Raymond James.

Also, stick with what are known as general-obligation munis. These bonds are backed by a city or state's taxing power, unlike riskier "revenue" bonds that survive off the money generated from a specific project, such as a housing development.

Ladder individual munis. Owners of individual securities face the risk not just of a potential default but of tying up their money at the lowest possible yields.

To get around this, construct a "bond ladder," says Schwab fixed-income strategist Kathy Jones, in which you would invest an equal amount of money in munis (or other types of bonds) of varying maturities.

So instead of purchasing all 10-year bonds, buy securities maturing in, say, one, three, five, seven, and 10 years.

As the shorter-term bonds expire, reinvest the money at the upper end of the ladder. That way, says Jones, "you earn income on the longer-maturity bonds and have the flexibility to reinvest if rates move up."

Diversify with high-quality funds. If you live in a financially fit state like, say, Indiana or North Carolina, going with a single-state muni fund may be all the diversification you need -- plus, you'd get the added boost of that income also being state tax free. Elsewhere, you're better off with a national fund that will prevent the bonds of any one city, county, or state defaulting and wrecking your portfolio.

Further reduce risk by sticking with funds that invest only in investment-grade debt -- muni bonds rated BBB or higher. For even more safety, go with ones whose average holdings are A-rated or higher. (Look this up at Morningstar.com.)

Finally, avoid funds that invest in long-term debt, because those bonds are more susceptible to potential losses if rates rise.

So keep an eye on something called "duration," which measures a fund's sensitivity to interest rate hikes. A fund with an average duration of seven could lose 7% if rates were to climb one percentage point. The average duration for all municipal bond funds is 6.1, so stay below that threshold. Vanguard Intermediate-Term Tax-Exempt (VWITX), a MONEY 70 pick, fits the bill with an average duration of 5.2 years.

Think I-bonds, not TIPS

Inflation can pose just as big a problem for Treasuries as rising rates do. Right now a new 10-year Treasury pays you 1.98% a year. But consumer prices have been rising at an annual rate of 2.7%. So on an after-inflation basis, you lose.

That's likely to continue being the case, since the market expects inflation to hover at 2.3% over the next 10 years.

Unfortunately, the standard solution for this, Treasury Inflation-Protected Securities, or TIPS, won't work this time. Every six months the principal value of these special government-issued bonds is adjusted to reflect changes in the consumer price index.

Demand for the bonds has been so high, though -- investors added $10.8 billion to TIPS funds last year, up from $900 million in 2007 -- that rates on many TIPS are actually negative.

"Investors are saying, 'Damn the torpedoes, full-speed ahead! I don't care about yield. I only care about inflation,' " says Marilyn Cohen, president of Envision Capital.

TIPS aren't your only option. The government offers another type of inflation-protected debt known as I-bonds. Unlike TIPS, I-bonds come with two rates: a fixed rate set when you buy the bond, and another that's adjusted for inflation every May and November. The fixed rate stands at 0%, but the second, when annualized, is 2.2%. That's still not great, "but it's better than negative," says financial planner Gary Schatsky.

Plus, I-bonds are exempt from state and local income taxes, and you can defer federal taxes until you redeem the bonds (with TIPS, you pay taxes annually).

You can buy individual I-bonds directly from the government at TreasuryDirect.gov. They can be held for up to 30 years but redeemed in full after just 12 months, minus an early-withdrawal penalty of three months' interest.

Hold the bond for five years, and the penalty is waived. One drawback: You can invest only up to $10,000 in one year (and another $5,000 if you buy with your tax refund).

Opt for low-penalty CDs, not short-term bond funds

Everyone needs to keep some cash at all times. But today cash accounts are yielding nada. The average rate on bank savings and money-market accounts with FDIC insurance (which covers up to $250,000 per depositor per bank) is a paltry 0.13%.

You could try an ultra-short-term bond fund in hopes of eking out better returns, but that's exposing that cash to potential market losses. A better alternative: long-term CDs.

Granted, you're tying up your money, and if your withdraw too early you'll pay a penalty, generally three months' interest and up. But Ally Bank offers a five-year CD yielding 1.68% with a penalty of only 60 days' interest.

"You get a fantastic one-year return, with the ability to pull out if rates increase," Schatsky says. Plus, you'll have FDIC insurance.

Choose the right kind of annuity

Conventional wisdom says you should withdraw just 4% from your accounts when you retire, adjusting annually for inflation. There's research that suggests that even that may be too much if you want your money to last three decades.

So how do you generate more income? You could risk the safety of your nest egg and be more aggressive with stocks. Or you could try to boost your annual withdrawal rate and pray that your money lasts throughout your retirement. The smarter choice is to take some of your money and buy a fixed immediate annuity.

Annuities are often taken to task for being expensive and hard to understand. But this type is an exception.

With an immediate annuity, you invest a lump sum with an insurer, and in return you get a monthly check for the rest of your life, whether you live to be 80 or 120. The amount you receive depends on interest rates and your age at the time of purchase -- the higher both are, the more you get.

But even with today's low yields, a 65-year-old male who annuitizes $100,000 can get annual income as high as $6,950, roughly equivalent to an initial draw-down rate of 7%. That's pretty generous, especially when compared with what you'd get if you tried to do this on your own.

You can play it even safer. For instance:

Don't go all in. The one drawback to most immediate annuities is that you forfeit the lump sum. If you don't live very long, the money remains with the insurer instead of passing to heirs. You also can't tap the money in case of financial emergencies.

So wealth manager Chris Cordaro recommends annuitizing only a portion of your savings -- say, enough to cover fixed costs such as utility bills and health care premiums.

Diversify your annuities. Worried about missing out on higher rates by locking in an annuity now?

Cordaro recommends staggering your annuity investments, placing only a portion of the total lump sum you intend to use into separate annuities over a few years. Think of it as a slow version of dollar-cost averaging.

You'll also be able to invest across several insurers, minimizing the potential risk that one of those firms will go bust.

More ways to Make your money safer:

How to pick stocks without being burned

7 low-risk funds for the long haul

'Safe' investments that are actually risky  To top of page

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