SAFE INCOME INVESTMENTS THAT CAN RETURN 20% OR MORE LOW-RISK BONDS AND INTEREST-RATE-SENSITIVE STOCKS OFFER THE BEST RETURNS OVER THE NEXT 12 TO 18 MONTHS.
(MONEY Magazine) – For dazed stock investors, it's been an unusually rollicking ride on the stock market roller coaster lately. After rising 9.3% in the first five months of the year, Standard & Poor's 500-stock index fell 7.6% by late July, only to climb back up 5.7% by early August. The technology-heavy NASDAQ composite was even more stomach-churning. It rose 26.4% from January to June, plunged 16.6% by late July and then went up 7.9%.
But don't lose your nerve. There are plenty of high-quality investments--both bonds and interest-rate-sensitive stocks--that offer top returns within the next year, with less volatility. In fact, a growing number of analysts think bonds are now a better value than stocks, for two reasons. First, the benchmark 30-year Treasury bond recently yielded about 7%, vs. the S&P dividend yield of just over 2%. Second, corporate profits are expected to grow more slowly and perhaps even decline early next year. Says Daniel Fuss, president of the Loomis Sayles Funds: "Usually I have a bias toward stocks, but bonds are clearly the better buy now." Adds Jim Floyd, senior analyst at the Leuthold Group, a Minneapolis institutional research firm: "Over the next 12 months, bonds should outgain stocks with less risk."
Still, bonds--disappointing performers so far this year, with losses of about 8% in total returns--entail risk too. In the topsy-turvy bond market, good news one day--say, unemployment at a low 5.3%--causes bond prices to plummet. Bad news the next day--perhaps economists' forecast that growth will slow to 2% or less next year--leads to a rally. How's an individual investor to profit? Advises Ian MacKinnon, head of fixed income for the Vanguard mutual funds: "Ignore the day-to-day gyrations of the bond market, and you'll see there's real long-term value to be had."
MONEY chief investment strategist Michael Sivy and other analysts think that economic growth will slow to around 2% later this year and next (see "Beat the Stock Market Jitters" on page 58). That should restrain inflation and push long-term interest rates down a full percentage point to about 6% within 12 months. Such a decline would produce 20% total returns on 30-year Treasury bonds and boost returns from interest-rate-sensitive stocks, such as real estate investment trusts (REITs), utilities and preferred issues.
Before you rush out to buy these investments, however, two caveats. We're not recommending that you sell all your stocks to buy bonds. That kind of market timing is usually futile, and you'll likely end up with a hefty tax bill to boot. Use any new savings or the proceeds from selling investments that strike you as too risky in today's market. Second, plan to hold your bonds for 12 months or longer, and ignore any signs of panic among nervous bond traders if interest rates creep up for two or three months before they head down.
Here, then, are today's most attractive income investments, both individual securities and funds that hold them. We begin with three classes of bonds and conclude with three types of high-yielding equities. For data on the funds, see the table on page 70.
U.S. GOVERNMENT BONDS
--Zeros. Rather than pay cash interest, Treasury zeros give bondholders a lump sum at maturity that includes principal and the accrued interest that was not paid out during the life of the bond. Zeros--also called strips--are ideal for investors aiming for capital gains if interest rates decline, as Sivy and many other forecasters expect. Reason: Zeros' prices rise or fall more sharply than those of other bonds when rates change. Says Bubba Bennett, director of fixed-income marketing at Prudential Securities in New York City: "With yields now above 7%, zeros are an extremely attractive way to shoot for big profits." If rates fall a full percentage point over the next 12 months as our forecasters expect, 20-year Treasury zeros, currently yielding 7.35%, will return 30%, vs. 18% for regular 20-year T-bonds. On the other hand, if rates rise a percentage point, the zeros will lose 12%.
High flying? Sure. But zeros may also be appropriate for buy-and-hold investors with fixed goals in mind, such as retirement. Says James Benham, chairman of the Benham funds: "Strips allow you to lock in a high rate of return for a specified time period with no principal risk--as long as you hold them to maturity." For example, $10,000 invested today in 20-year zeros would be worth about $41,310 when they mature. One tip: Whenever possible, hold zeros in a tax-deferred account, such as an Individual Retirement Account. Otherwise you'll owe federal taxes on each year's imputed interest even though you won't receive it until your bond matures.
You can buy strips for as little as $1,000 from any full-service broker who specializes in them. Bond experts recommend zeros with 10- to 20-year maturities for buy-and-hold investors. Because of a quirk in the yield curve, these intermediate-term issues actually yield slightly more--and are less risky--than longer-term issues.
Fund investors can choose among six Benham funds that hold zeros to maturity. Three with maturities in the 10- to 20-year range are Benham Target Maturity 2005, Target Maturity 2010 or Target Maturity 2015.
--Treasuries. Investors who want to pocket bond interest payments and get protection against default should buy U.S. Treasury issues. Like interest that accrues on zeros, the interest paid by Treasuries is exempt from state and local taxes. Investors gunning for capital gains should buy T-bonds with maturities of 25 years or more. For the buy-and-hold investor, bond pros recommend 10-year Treasuries, because they provide 98% of a 30-year bond's yield with only 60% of the risk. If rates fall one percentage point, a 10-year Treasury's total return will be a respectable 13%.
You can buy individual Treasuries in $1,000 amounts from a broker for a commission of $10 to $30. Or if you plan to hold your bonds to maturity, you might purchase them at no cost from the Federal Reserve. (Call your nearest regional Federal Reserve Bank for information.) Fund investors should consider $1.2 billion Vanguard Fixed-Income Intermediate-Term U.S. Treasury. Its rock-bottom annual expenses of 0.28%, vs. 0.8% for the average Treasury fund, help boost its yield to an enviable 6.4%.
--Ginnie Maes. Government National Mortgage Association bonds, called Ginnie Maes, have Uncle Sam's implicit guarantee and yield one-half to one percentage point more than Treasuries of comparable maturities. The bonds are backed by pools of home mortgages. Your risk is that falling interest rates will encourage homeowners to refinance their mortgages, which will cause your principal to be returned sooner than you expected, and you will have to reinvest it at lower rates. However, pros say this risk is minimal now, since most homeowners likely to refinance did so when rates dropped dramatically last year. Even so, our experts say it's best to invest in a GNMA fund and leave analysis of these com- plex issues to the pros. One top performer: $1.1 billion Benham GNMA Income, which yields 7%. Like other Ginnie Mae funds, it has a triple-A rating; better, it has beaten 91% of its peers, posting an average annual return of 8.6% for the past 10 years.
--On an after-tax basis, tax-exempt state and local bonds generally put more money in the pockets of investors in the 28% tax bracket or higher than do Treasuries of comparable maturities. For example, top-rated 10-year munis recently yielded 5.2%, which for investors in the 28% bracket--taxable income starting at $24,000 if single, $40,100 if married and filing jointly--is equivalent to a taxable yield of 7.2%. That's three-tenths of a percentage point more than 10-year Treasuries were recently yielding. Bond experts say the best values for buy-and-hold investors are five-to-15-year municipals, because you get 83% to 95% of a 30-year bond's yield with just 40% to 75% of its risk.
Investors with $100,000 or more can buy individual issues in lots of $25,000. Use a broker who is experienced in trading the bonds. To guard against default, buy only bonds graded double A or higher by two rating agencies, such as Moody's and Standard & Poor's. Stick to general obligation (G.O.) bonds, which are backed by a state's taxing power, or to revenue bonds backed by income from an essential service such as water or power. No state has ever defaulted on a G.O. bond. And, says James Cooner, head of the Bank of New York's tax-exempt bond management division: "Water, sewer and other must-use services produce reliable incomes. If you don't pay your water bill, you don't take a shower." Another tip: Look for insured bonds, which are automatically rated triple A by virtue of their insurance and yield one- to two-tenths of a percentage point more than uninsured triple-A issues. This yield difference results from the fact that the market perceives insured triple-A issues to be slightly more risky than top-rated bonds without insurance.
Investors with less than $100,000 to put in tax-exempts--or those seeking broad diversification--can buy muni bond funds. A leading candidate: $5.9 billion Vanguard Municipal Intermediate-Term, which recently yielded 5.2% and has returned an average of 5.4% annually over the past three years, which puts it in the top 8% of its category. Managers Ian MacKinnon, 48, and Chris-topher Ryon, 40, have loaded up their portfolio with 638 different issues carrying an average double-A credit rating.
--Foreign bonds. Foreign debt issues can boost your returns while actually reducing your portfolio's overall risk. Explains financial planner Harold Evensky of Coral Gables, Fla.: "Foreign economies move in different cycles from our economy, as do foreign currencies from our dollar." Thus when U.S. bond prices fall, some foreign bond prices rise. Since foreign issues can be hard for individuals to analyze, you're better served investing 5% to 10% of your bond allocation in a broadly diversified fund. Evensky likes $990 billion T. Rowe Price International Bond. Manager Peter Askew, 43, has invested 75% of his assets in European government issues, which are benefiting from sluggish local economies and falling interest rates. Over the past five years, the fund has returned an annualized 11.4%, beating 95% of its peers.
If you're willing to take a bit more risk for a higher return, buy a fund that invests in the Brady bonds issued by such countries as Argentina, Brazil and Poland. The U.S. Treasury guarantees the principal of these dollar-denominated bonds, and they yield two to four percentage points more than Treasuries. "With Brady bonds you take no principal or currency risk yet are handsomely compensated," says Michael Metz, chief investment strategist at Oppenheimer & Co. in New York City. But bondholders do run the risk that foreign governments will default on interest payments, which are not guaranteed by the U.S. Metz says that risk seems low today, however, because the countries can't afford to alienate foreign investors. What's more, many of their economies are in substantially better shape than they were when Brady bonds were first issued in 1989.
Mark Wright, fixed-income analyst at Morningstar, favors $250 million Scudder Emerging Markets Income, which has returned 33% over the past year. Managers Susan Gray, 30, and Isabel Saltzman, 41, have invested 57% of their assets in Brady bonds and the rest in other foreign government and corporate issues. Since 98% of the fund's holdings are denominated in U.S. dollars, the fund's investors face almost no currency risk.