Where You Can Get High Income -- Safely Guard against an interest rebound with a mix of short-term bonds, high-yield stocks and money funds.
(MONEY Magazine) – The bond market is up to its new tricks again, bucking like a young bull. Long-term interest rates have fallen nearly two percentage points since October, rewarding holders of bonds and bond funds with capital gains of about 20%, to the envy of stock owners. It may be rather late, though, to hop on the long bond wagon. Looking warily ahead, economists and investment advisers urge income investors to take precautions against another reversal later this year, sending interest rates up again. In the eternal seesaw between rates and prices, that would drop the value of bonds. The pros are not yet ready to shout sell, however. Their counsel for now to income seekers is to confine new investments to a mixture of short- and intermediate-term bonds, plus high-dividend stocks, certificates of deposit and money-market funds. But if you are already living on the high yields from long-term bonds, with no intention to sell them in the next few years, you can probably afford to sit out the coming turbulence. An onset of weakness in the bond market, paradoxically, may come from economic strength. Many analysts who until recently expected a recession this year now think that stronger exports, increased factory orders and presidential politics will grant a reprieve until 1989. A chief exponent of that point of view is Allen Sinai, the man on our cover. Sinai, chief economist of an American Express investment advisory firm, the Boston Co., and head of its consulting subsidiary, Economic Advisers Inc., correctly forecast that rising interest rates would cause trouble for financial markets last year. He now believes that continuing strength in export sales and manufacturing, plus a pickup in consumer spending, will revive economic growth in the rest of 1988. Stepped-up production would then strain factory capacity, which would worsen inflation, putting upward pressure on interest rates. One pillar of economic recovery has been the dollar's 18% fall last year against the currencies of major U.S. trading partners. A weakened (but lately stabilizing) dollar is making American goods more competitive abroad and is cutting the trade deficit. Thus encouraged, Roger Brinner, chief economist of the forecasting firm Data Resources Inc., predicts slow growth but no recession this year. ''We think strength from exports will rescue the economy in 1988,'' he says. But Brinner too sees higher inflation and higher interest rates coming as a consequence. Neither he nor Sinai expects a return to the double-digit levels of the 1970s, but both think consumer prices will climb at about a 4.5% annual rate by year-end, compared with about 3.5% in the first quarter. The conviction that a recession will be delayed until next year is reinforced by the politics of a presidential election year. The party in power can almost unfailingly be counted on to bend its policies toward allaying fears of the electorate, and financial forecasters are factoring this assumption into their outlook. ''No President wants the voters in the fall to have to push through the unemployment lines to get to the polls,'' declares Richard Young, editor of Young's World Money Forecast (Federal Building, Thames Street, Newport, R.I. 02840; $425 a year), a twice-monthly commentary. Sinai's forecast, charted below, comes to a fork in the road this spring. As he sees it, interest rates as exemplified by long-term Treasury bonds are likely to run flat until June and turn up in the second half. But there could be an alternative course leading to even higher rates in the event of sharply rising inflation, a substantially weaker dollar or other bleak news. In light of this risk, Sinai counsels people with money to invest in the bond market to ''concentrate now on preserving their capital.'' He and other advisers suggest keeping at least a third of any new cash in money-market funds, where it will be available for later investment. Then, if interest rates do rise sharply in the second half, you could move that cash into longer-term bonds, those maturing in 10 years or more, to grab higher yields. For now, however, most bond investments should be limited to securities or mutual fund portfolios with average maturities of seven years or less. At small sacrifice in yield, bonds that come due in a few years give you a cushion against sharp declines in market value when rates take off. Strategies for income investors depend, of course, on their goals and sensitivities. If you are about to retire and feel that protecting your capital is paramount, you should probably stick with CDs. Their federal deposit insurance, covering amounts up to $100,000, should soothe the nerves. And risk-free yields of 8.1% on five-year certificates aren't too shabby. You can reach for higher returns, though, with capital earmarked for a definite time further ahead. Money reserved for, say, a college education can go into bonds with maturity dates that match tuition due dates. Nervier investors who want only to shoot for the best possible total returns might want to consider using bonds with long maturities for a timing strategy. This calls for switching back and forth between bond mutual funds and money- market funds. (See the box on page 90.) If you already own long-term bonds, or bond funds heavy with them, at least reexamine your position. How soon might you need the money? How terrorized might you feel if the value of your portfolio fell? If you are going to need the money in the next 18 months and you would feel awful losing any of it, switch to maturities of seven years or less. On the other hand, if your long- termers are yielding 9% or more in an IRA or some other untouchable retirement account, it makes great good sense to stand fast. Inevitably, as in all economic cycles, rates will fall in the next recession. Indeed, Allen Sinai believes that rising interest rates will choke off economic activity and bring on a recession in the classic manner by the second half of 1989. According to that scenario, long-term bonds might produce capital gains in short order. Whether you wish to be supercautious or take some risk and whether you decide to go short term or stay long, your choices are many. They range from unassailably high-quality securities at modest yields to temptingly high- yielding bonds of less than investment grade. So let's analyze the choices: Treasury securities. As America's creditors know so well, investing in U.S. Treasuries eliminates two sizable problems. One is credit risk, the chance that the borrower won't pay you back. The other is call risk, the chance that if interest rates fall the borrower will repay the debt before it is due. Most corporate and municipal bonds can be refinanced after a few years, but 30-year Treasuries can't be called for 25 years. When interest rates rise, however, Treasuries behave just like other bonds -- they fall in price. So for now it's probably best to concentrate new purchases in maturities of seven years or less. With seven-year Treasuries you recently could get 8% interest, compared with about 8.5% on 30-year bonds -- a difference in return of only $5 a year per $1,000 invested. If overall interest rates later rose by a full percentage point, the 30-year bond would lose about 10% of its value; the loss on the seven-year bond would be only about half that. By dropping to three-year notes, you could still get 7.5%, and the comparable risk to market value would be only one-third that of a 30- year bond. A technique called laddering can also hedge your risk against interest-rate fluctuations, but only if you have $20,000 or more to work with. You buy a series of Treasury notes and bonds with a range of maturity dates from, say, three to 12 years. Since some of your securities come due every year or two, you will have money to reinvest if interest rates rise and other money locked in at current yields if rates fall. Municipal bonds. Though yields on tax-exempt munis have been falling along with those on taxable issues, the returns are nevertheless unusually high. The reason is a weak demand for munis, prompted partly by the loss of tax exemption by banks and other big buyers under tax reform. But demand has begun picking up as taxpayers focus on their 1987 Form 1040s. Analyst S.E. Canaday of the municipal bond firm John Nuveen & Co. believes that municipal yields could move slightly lower by June even if yields on taxable Treasuries and corporates hold steady. For now, municipals outearn taxables of comparable quality in terms of after-tax yields if you are in the 28% or 33% tax bracket. Long-term munis, at their recent yield of 7.5%, were paying about 88% of Treasury rates -- well above the historical average of 72%. To equal a tax-exempt 7.5%, a 33% taxpayer would have to get an 11.2% taxable yield and a 28% taxpayer would need 10.4% -- well above anything lately available on Treasuries or high- quality corporates.
With municipal bonds, the reward for buying maturities beyond seven years is greater than that from other bonds. A double-A rated 12-year tax-exempt, for example, was recently yielding 7.1%, vs. 6.2% for a seven-year bond of the same quality. The biggest worry about munis may be the liquidity of many lesser-known and thinly traded issues. You might have trouble finding a buyer for them quickly at a reasonable price. And to diversify adequately against risk to any one issue, you should own at least seven different bonds. The solution to both problems is to buy a municipal bond mutual fund. Major fund sponsors such as Dreyfus (800-645-6561), Vanguard (800-662-7447), Fidelity (800-544-6666) and Scudder (800-225-2470) offer long- and intermediate-term tax-exempt funds. Portfolio manager Susan Peabody of the Alliance Tax-Free Income Fund (800-221-5672) suggests another mutual fund advantage: professional fund managers are likely to spot the trickily worded early-call provisions that sometimes lie buried in bond covenants. If you live in a high-tax state such as California, Massachusetts or New York, you may want to seek out a fund that invests only in bonds of that state. As a resident, you are exempt from state, local and federal tax on the interest. Corporate bonds. When compared in yield and safety with municipal and Treasury bonds, high-grade corporates look pallid. Furthermore, the resurgent wave of company takeovers has reintroduced a danger to corporate bondholders that has not been widely recognized. Takeovers and leveraged buyouts, which usually are financed by a load of new debt, can turn a company with a strong credit rating into a potential delinquent almost overnight in the estimation of bond rating services. The price of a downgraded bond typically falls, producing a loss that bondholders may not be able to recover until maturity. With a recession perhaps not too far away, income investors must pay extra attention to the creditworthiness of their bonds. A serious business slowdown increases the danger of default by issuers whose balance sheets are burdened with debt. As a result, junk bonds, those rated BB or lower, are about the only corporates around with attractively high yields. A BB-rated issue of Coastal Corp., an oil refiner, maturing in 2006, yields 11.75%. Recession fears help explain the wide spread between that and the 9.5% yield on equivalent issues of investment grade. The issuers of junk bonds typically suffer worse financial blows than more solid corporations when business falls off. Mutual funds can help you here too. Some funds labeled high yield contain, in reality, very little true junk. It is probably safe, at least for now, to go for higher yields in such no-loads as Value Line Aggressive Income (800-223-0818) and SteinRoe High-Yield Bond (800-338-2550). If a serious recession is widely reported as getting under way, however, even these funds may suffer guilt by association.
High-dividend stocks. Your money can grow in dividend-paying stocks even though interest rates do not fall. Many strong companies raise their dividends regularly. The shares of such companies also usually rise. By the same logic, of course, they will fall on news of poor earnings or a recession. During much of 1987, dividend-minded investors found little to buy. Richard Young, who dotes on dividends, told anyone who read his newsletter or heard his speeches last spring and summer that the 2.5% composite dividend yield of the 30 blue-chip stocks used to compile the Dow Jones industrial average was sounding a warning. Since the stock market crash, however, the yield for the Dow has climbed to about 3.4%, and Young can readily find stocks that meet his requirements by exceeding not only the present Dow yield but also its historical average of 4.6%. Young's picks center around public utilities, with a mix of water, electric and telephone companies. In the first group, he favors California Water Service (recently traded over the counter at $29.75, yield 5.4%) and American Water Works, a holding company for utilities in New England, the Midwest and California (New York Stock Exchange, $15.50, yield 4.4%). American Water Works' payout seems low until you learn that it has raised its dividend an average of nearly 10% a year since 1975. In electric utilities, Young recommends diversifying by fuels. Oil, coal and nuclear power each has its risks, whether it is a nuclear meltdown scare, rising oil prices or acid rain. So don't put all your money on any one fuel. His selection among oil-fired utilities is Hawaiian Electric (NYSE, $29.75), with a 6.4% yield. He also likes Potomac Electric Power (NYSE, $22.25, yield 6.2%), whose mostly coal-burning plants service the Washington area; and San Diego Electric & Gas (NYSE, $32.25, yield 8%), which generates 22% of the power for its fast-growing area at nuclear plants. Young thinks that all of the Baby Bell regional telephone company stocks look attractive, but he particularly likes Nynex (NYSE, $69.25, yield 5.5%) and U.S. West (NYSE, $55, yield 6%). Finally, he adds to this income-oriented list two oil company stocks that combine high dividends with the ability to profit from resurgent inflation brought on by rising oil prices. He suggests Mobil (NYSE, $43.50, yield 5%) and Royal Dutch (NYSE, $114.50, yield 5.5%). High yields from stocks are no guarantee that they are safe investments. And some other income producers, such as Ginnie Maes and real estate investment trusts, offer higher yields than do stocks or even bonds. But when interest rates rise, long-term Ginnie Maes suffer the same losses as bonds. And with commercial real estate already troubled and the outlook for housing uncertain, most advisers consider REITs unworthy of their extra risk. On the current economic weather map, they say, it is foolhardy to stretch for higher yields. When that telltale low-pressure recession area is not far away, you want to be sure your capital has a safe place to ride out the storm.
BOX: Check It Out Timing can pay off in bonds too
Last October's crash was another reminder of the ruinous swings that stock prices can take. But in seven of the past 10 years, bond prices have been more volatile than the stock market. For that reason, there are money managers who advocate switching in and out of the bond market, and such a strategy might make sense for adroit investors. Success, however, requires time, nerve and, almost certainly, outside advice. The modern era of swiftly moving interest rates has brought forth advisory newsletters that signal when to move into bond mutual funds and when to take cover in money-market funds. Last year's roller-coaster ride for bond prices put these services to a rugged test. Capital losses sliced so deeply into yields that the average bond fund showed a total return of just 1.4%. Followers of two top bond-timing services did considerably better, however. The bond portfolio in Paul Merriman's Fund Exchange (1200 Westlake Ave. North, Seattle, Wash. 98109; monthly, $125 a year) produced a 10.2% total return. Merriman also beat the average bond fund in 1985 but trailed it by about four percentage points in 1986. The Davis/Zweig Bond Fund Timer (P.O. Box 5345, New York, N.Y. 10150; 16 issues a year, $150) returned 8.4% in 1987, its inaugural year. Until lately, both services had kept their readers fully invested in bonds, but Davis/Zweig is now telling subscribers to switch half of their bond capital to money funds. Timing has risks of its own. Failure to make a switch soon after the signal flashes, or a wrong signal that keeps you in bonds when rates are rising, can derail your profits. Furthermore, the capital-gains tax can sponge up as much as 40% of your gains in some states. Still, a generally accurate bond-timing service can keep income flowing and preserve your capital no matter which way interest rates turn.
CHART: TEXT NOT AVAILABLE CREDIT: NO CREDIT CAPTION: Sinai's scenarios
Long-term interest rates -- as economist Allen Sinai sees them -- will remain flat through June, then rise as the economy heats up. The red line tracks a second, darker sce nario: still higher rates, which he believes could result ^ from a falling dollar, unexpectedly high inflation or some other unpredictable piece of bad news. DESCRIPTION: Allen Sinai's predictions for interest rates through March, 1989.