The Best Places To Put Your Savings Now Our pros pick 10 solid income-producing investments that won't collapse when interest rates climb.
(MONEY Magazine) – Picture the bond market as a peaceful hamlet. But wait -- what is casting that ominous shadow across the village square? Has Frankenstein's monster returned to send the townspeople fleeing in terror again? The monster, of course, is rising interest rates. The Federal Reserve brought the nasty creature to life with the early February announcement that it would push up rates for the first time in five years. Should you be spooked too? No. But if you're an income investor, you do need to revise your strategy to survive this new gothic tale. This article will help you do just that. The Fed's declaration should actually have calmed bond traders by demonstrating the central bank's willingness to fight inflation, which erodes the value of fixed-income investments. Instead, the twitchy institutions interpreted the tiny quarter-point increase in the federal funds rate to 3.25% -- and Federal Reserve Board chairman Alan Greenspan's subsequent statement that short-term rates would probably have to rise even further -- as a death knell for the 12-year bull market in bonds. By the beginning of March, the price of the Treasury's benchmark 30-year bond had fallen about 6%, lifting the yield to 6.77% from 6.3%. Some economists predict the rate may hit 7.25% by the end of the year, dropping prices another 6%, while rates on bonds of other maturities increase by similar amounts. (For more on the interest-rate outlook, see Money Forecast on page 174.) In this climate, income investors face a dilemma. Although long-term fixed- income investments offer the highest yields, they can also suffer the sharpest price declines. On the other hand, the Fed's little upward nudge wasn't nearly enough to make ultrasafe short-term investments attractive. Since the Fed's move, for example, the average six-month bank certificate of deposit has hiccuped to 2.8% from 2.78%, while three-month Treasury bills have spiked to 3.5% from 3.1%. So where do you turn for the best yields with the least risk? Looking ahead over the next 12 months, tax-free municipals, intermediate-term bonds, mortgage-backed GNMA funds, junk bonds and real estate investment trusts all offer the prospect of steady income without being overly vulnerable to rising rates. Because it makes sense for a majority of individuals to buy these securities through mutual funds, we have asked fund analysts to recommend the ones that they think offer the safest, highest yields. Their 10 picks, all no- loads, are listed in the table on this page and discussed in detail in the text that follows, grouped according to their risk level.
Very low risk Money-market mutual fund investors get an almost immediate lift from swelling rates. That's because money funds hold paper with such short maturities -- averaging 30 to 60 days -- that new, higher-yielding issues quickly replace < lower-yielding ones. You'll find lists of the leading taxable and tax-free money funds in Money Monitor on page 36. But if you are investing for at least three years, money-market funds are not your best choice even when interest rates are on the upswing. Michael Martino, a senior vice president at the Putnam mutual fund group, studied the eight periods since 1955 when interest rates have risen for two years or more. He then worked out what would happen to various investments if the next three years followed the pattern of the past. Martino's conclusion: Short-term bond funds would average a total return of 12.5% for the three years, while money- market funds would return only 9.5%. The explanation: The bond funds' higher yields would more than make up for the slight losses in principal inflicted by higher rates. Among short-term funds, Norman Fosback, editor of the newsletter Income Fund Outlook ($49 for 12 issues; 800-442-9000), recommends Scudder Short-Term Bond Fund (recent yield: 5.3%; 800-225-2470). The fund's portfolio has an average maturity of two years but a duration of just 1.5 years, according to the fund ranking service Morningstar. Duration, which is average maturity adjusted for the likelihood of the bonds being paid off early by their issuers, gives a better indication of the fund's exposure to losses from rate increases. The shorter the duration, the less the fund is likely to lose. In this case, if short-term rates climb another half a percentage point, as many experts expect, the Scudder portfolio would shed just less than one percentage point in value. Lead portfolio manager Thomas Poor has built up the yield while keeping duration down in part by putting 9% of the fund in foreign short-term issues, chiefly short-term Mexican government bills paying about 10%. Fosback also recommends Fidelity Short-Term Bond (yield: 5%; 800-544-8888). Manager Donald Taylor recently had about 26% of fund assets in high-yielding foreign securities; he favors those from countries whose currencies are pegged to the dollar, thus almost eliminating the danger that an appreciating greenback would erode returns. Over the past five years, Fidelity Short-Term Bond has been less risky than 90% of its competitors, according to Morningstar. Currently, it has a maturity of 2.9 years and a duration of 1.6 years. Investors in the 28% federal income tax bracket and above can get an even higher after-tax return -- with just slightly more risk -- by investing in T. Rowe Price Tax-Free Short-Intermediate (yield: 3.9%; 800-638-5660), paying the equivalent of a taxable 5.4% for a 28%-bracket taxpayer (taxable income of $22,101 to $53,500 for singles and $36,901 to $89,150 for couples), and 5.7% for a 31%-bracket taxpayer (taxable income of $53,501 to $115,000 for singles and $89,151 to $140,00 for couples). Manager Mary Miller concentrates on top- rated bonds, which carry the least risk of default, while maintaining an average maturity of 3.2 years and a duration of 2.5 years.
Low risk For most bonds, falling rates are an unmixed blessing and rising rates an unmitigated curse. But that's not so for mortgage-backed securities. In 1993, when the average 30-year fixed mortgage rate dropped from 8.5% to 7.4%, funds investing in Government National Mortgage Association (GNMA) securities averaged a return of just 6.9% -- compared with 11.3% for Treasury funds. That's because homeowners take advantage of declining rates by refinancing to pay off their existing high-interest mortgages. The GNMA funds holding bonds backed by those mortgages get the homeowners' cash, which they then must reinvest at the lower rates. Result: shrinking income for fund shareholders. When interest rates start moving up, GNMAs suffer principal losses along with other fixed-income investments. But they also benefit as mortgage prepayments slow down or stop, lifting the funds'yields. "GNMAs have a silver lining," says Randy Merk (pictured on page 103), who, along with Jeff Tyler, manages Benham GNMA Income (yield: 5.8%; 800-472-3389). "The slowdown in prepayments will help offset the pain of rising interest rates. With Treasury bonds, there is no silver lining." Merk predicts that over the next few months, mortgage prepayments will drop by 30% to 40%, which could hike the fund's yield by as much as half a percentage point, to 6.3%. Moreover, for the past year, Merk has reinvested cash from prepayments in short-term issues, lowering the fund's duration to 3.2 years. Thus if rates moved up half a point, the fund would stand to lose less than 2% in principal value -- a blow that would be softened by the increased yield. And after a year, the income payments would leave you ahead of a money fund, for example, even with the principal loss. The fund carries 64% of the risk of the average taxable bond fund, according to Morningstar. A mortgage fund with a lower yield but even less risk is Fidelity Mortgage | Securities (yield: 5.7%; 800-544-8888). Manager Kevin Grant has assembled a portfolio with an average maturity of 8.5 years and a duration of 2.4 years. Morningstar says it has 57% of the risk of the average taxable bond fund. Investors who want to hedge their bets by mixing GNMAs with additional income investments might consider T. Rowe Price Spectrum Income (yield: 5.7%; 800-638-5660). The fund invests in other T. Rowe Price funds but does not add its own layer of expenses. It recently had 15% of assets in the Price GNMA fund, 24% in the New Income intermediate-term corporate fund, 22% in the high- yield fund, 18% in the international bond fund and a smattering of smaller allocations. Partly as a result of this eclectic mix, Spectrum Income has only 17% of the risk of the average taxable bond fund. Strong Municipal Bond (yield: 5.1%; 800-368-1030) delivers its above-average tax-free yield (worth 7.1% to taxpayers in the 28% bracket, 7.4% to 31%- bracket taxpayers) with relatively low risk. Co-managers Thomas Conlin and Mary-Kay Bourbulas have assembled a portfolio with an average maturity of 19 years but a duration of only 6.7 years. And they've adopted a defensive stance to guard against rising rates. One strategy: After fears about the Clinton health plan helped knock down the prices of bonds issued to finance hospitals and other medical facilities, Conlin and Bourbulas snapped up issues that they believed were selling at a discount to their true value. They expect these bonds, which now account for a hefty 42% of the portfolio, to produce big gains over the next several years.
Moderate risk Since the price of junk bonds is more dependent on the health of issuers than on the general state of interest rates, junk bonds can be a relatively attractive income investment when rates climb. The burgeoning economy that pushes up rates also bolsters the balance sheets of companies that have issued junk bonds. Still, these below-investment-grade securities are susceptible to defaults, and the market has experienced precipitous declines during economic slowdowns. (For more on the junk bond market, see Buy, Sell or Hold in Money's March issue.) With those concerns in mind, Ralph Norton, editor of the Bond Fund Advisor ($95 a year; 800-343-5413), recommends sticking with junk bond funds that avoid the diciest issues. One of Ralph Norton's favorite junk bond investments is Vanguard Fixed Income High-Yield Corporate (yield: 7.9%; 800-662-7447). Manager Earl McEvoy ^ invests in higher-quality bonds than many of his competitors; the portfolio's combined Standard & Poor's credit rating is BB, three notches better than the B average for all high-yield funds. Nicholas Income (yield: 7.9%; 414-272-6133) also boasts an overall rating of BB. In 1990, when the typical high-yield fund suffered a loss of 10.3%, the Nicholas fund was down just 1%. Investors sometimes treat real estate shares (which pay high dividends) just like utilities and other income stocks, shunning them if they believe interest rates will rise. But that strategy may not be wise. According to a study by regional broker Alex. Brown & Sons in Baltimore, dividend growth exerts far more influence on the movement of REIT stocks than does the direction of interest rates. If that pattern holds, this should be a propitious moment to get into REITs. After staggering through a near depression during most of the 1980s, landlords of apartment buildings and shopping centers are finally finding that they can impose rent increases, thanks to the improving economy. As a result, Alex. Brown analyst Catherine Creswell expects REITs to average dividend growth ranging from 5% to 8% a year for the next three years, with the best ones increasing their dividends by as much as 15% annually. Creswell believes that the solid dividend growth will contribute to an average total return of 10% a year for the category, with top performers posting total returns of as much as 20%. For mutual fund investors interested in REITs, analysts recommend PRA Real Estate Securities (yield: 5.3%; 800-435-1405). Managed by Michael Oliver and Dean Sotter, this fund recently had 59% of its portfolio in REITs that own apartment buildings, with another 35% in REITs that own shopping centers and other retail properties, including fast-growing factory-outlet malls. Oliver and Sotter are betting that bargain hunting remains a favorite American pastime, no matter which way interest rates go.
CHART: NOT AVAILABLE CREDDIT: Source: Morningstar Inc. CAPTION: 10 FUNDS WHERE YOUR SAVINGS CAN GROW SAFELY These no-load mutual funds offer a nifty combination: They provide solid income and are especially well positioned to hold up if interest rates rise by half a point this year, as many analysts expect. They are listed in the order of their current yield.