THIS SUMMER'S BLOCKBUSTERS...BOND FUNDS WITH TREASURIES YIELDING AROUND 7% AND EVEN STOCK-PICKING GOD SIR JOHN TEMPLETON SINGING THEIR PRAISES, BONDS AND THE FUNDS THAT BUY THEM LOOK LIKE THE BIG HIT OF '97.
By JASON ZWEIG REPORTER ASSOCIATE: DEREK GORDON

(MONEY Magazine) – Picture a bond fund manager, and you probably envision a skinny chap with Coke-bottle glasses, a five-pound pocket calculator and skin so pale you'd think he bathed in chlorine bleach. Stock fund managers, meanwhile, ooze sex appeal. Stock investing is glamorous, bonds boring.

Not so fast. This March and April, Standard & Poor's 500-stock index dropped nearly 10% in just six weeks. It wasn't a crash, it wasn't even a "correction," and the market did bounce back strongly. But it was enough to galvanize the attention, if not the nervous attention, of every stock fund investor I know.

Meanwhile, bonds--as measured by Merrill Lynch's master index--lost just 2.1%. Better yet, in recent weeks even Sir John Templeton, the knighted granddaddy of global stock pickers, has been talking up the value he sees in bonds. And MONEY's own forecaster, Michael Sivy, thinks bonds could post double-digit profits over the next 12 months. That could be four or five percentage points greater than stocks. Suddenly, bonds look buff--less like Bill Nye the Science Guy and more like, well, James Bond.

My message: Buy bonds now! Since Sivy thinks long-term interest rates may be near a peak, today is as good a time to buy as there has been in years. In my view, every fund investor even young people, should have some bonds in his or her portfolio. Young investors should have up to 20% of their portfolio in bonds, investors in their prime years 30% to 40%, and retirees and near retirees 40% to 60% or more. Nevertheless, in recent years, many investors have seen bonds as being fit only for fuddy-duddies. That's because three dangerous myths have taken hold. As Bond's nemesis Oddjob would, let's attack them head on:

--MYTH ONE: Stocks return 11% a year, bonds half as much. Since 1926, according to Ibbotson Associates of Chicago, stocks have returned an average of 10.7% a year, intermediate-term Treasuries 5.2%. So what does that past tell us about the future? Just about zilch. In the long run, stock returns are driven by two solid things (earnings and dividends) and one sentimental thing (how high a price investors are willing to pay for those earnings and dividends). Corporate profits have grown at a long-term annual average of 6% to 7%, and the current dividend yield on U.S. stocks (as measured by the S&P 500) is below 2%.

There's no way around it: For stocks to return more than 8% to 9% annually, future investors will have to be even more optimistic--that is, pay an even higher price per dollar of earnings and dividends--than today's investors. Lately, blue-chip stocks have been selling at 19.8 times earnings and 50 times dividends. But as recently as 1984, they fetched just 10.8 times earnings and 21.6 times dividends. You're kidding yourself if you believe that stock investors will never get that gloomy again. The stock market has been very happy for the past few years, but it won't stay that way forever. I don't believe in market timing, and I certainly don't want you to dump your stocks. All I'm saying is that the future rate of return on stocks is a lot more uncertain than you might think.

Listen to William Gross, the bond boss at PIMCo, which runs more than $100 billion of fixed-income money. "I'm not suggesting terrible times ahead for stocks," says Gross, who's been called the Peter Lynch of bonds, "but I don't think the double-digit returns of the past few years can continue much longer. So bonds, at around 7%, are a practical alternative." He hastens to add, "That return isn't guaranteed, but over time the odds are good of coming pretty close to it."

--MYTH TWO: You should have all your money in the highest-returning investment. Okay, maybe stocks won't return 11% a year forever. Won't they still outperform bonds? After all, stocks beat bonds and cash in 84% of all the 10-year periods since 1926. How could anyone argue against odds like that?

Easy. In those 70 years, stock dividends averaged 4.6%--but today, they've dropped below 2%. Over the same long run, intermediate bond yields averaged 4.7%--but today, you can get a 7% yield to maturity on a 10-year zero-coupon U.S. Treasury. And the 7% payout on the Treasury is highly certain, while the return on stocks is not. Stocks tend to hit either a home run or a dribbler or to strike out. In 1990, they lost 3.2% of their value; then in 1991 they rose 30.5%; and in 1992 they gained 7.7%. During the same years, medium-term bonds got base hits every time, returning 9.7%, 15.5% and 7.2%, respectively.

The point: If you need to double your money in 10 years (for, say, your child's college bill), the current 7% yield on bonds should get you there with much less agitation than stocks.

--MYTH THREE: Stocks and bonds move in lockstep anyway. Diversification works best when you blend assets whose returns move in different directions, or at least at different rates. You want bonds and stocks to work like your own feet when you walk: As one goes forward, the other moves back, both propelling you smoothly toward your goal. But it has seemed lately that stocks and bonds were like two feet in the same shoe; both struggled in the first quarter of this year, both limped in 1994, both returned roughly 7% in 1992.

Think again, says Vanguard bond boss Ian MacKinnon--like PIMCo's Gross, one of the top bond managers in the country. Once you smooth out the short-term bumps by looking at five-year periods, says MacKinnon, stock and bond returns are less than 50% correlated, meaning that about half the time their returns do not move in lockstep--exactly what you want.

If this spring's markets didn't convince you that stocks aren't the only game in town, I hope I have. Next, I want to give you my six rules for successful bond/fund investing:

--RULE ONE: Know your time horizon. Far and away the biggest factor in determining your bond fund returns is how much interest-rate risk you take; short-term bonds that mature in four years or less have the lowest risk, intermediates (five to 10 years) a middling amount, and long-term bonds (11 years or longer) the most. That's because the longer you have to wait to get back your principal at maturity, the lower a long-term issue's price will sink if interest rates rise, since newer bonds will offer higher yields for longer periods. In 1994, for instance, medium-term Treasuries (maturing in roughly five years) fell 5.1%, but long-term Treasuries (due in around 20 years) dropped 7.8%.

A better measure of price sensitivity is duration, a number that combines future interest payments with the final payoff at maturity. A 10-year bond with a duration of seven, for instance, will fall in price by about 7% for each one-point rise in interest rates--and will gain about 7% if rates fall a point. These days, most fund companies will give you their average durations over the phone. If a fund has a duration of 12, ask yourself whether you can stand to lose 12% of your principal if interest rates rise one point. If not, find a fund with a lower duration.

In my view, most investors should not go beyond intermediate-term funds--those whose bonds have maturities in the five-to-10-year range and durations under eight. Over the past seven decades, intermediate bonds have returned an annual average of 5.2%, a hair better than the 5.1% return on longer-maturity bonds, with 37% less risk.

--RULE TWO: Watch your costs. High fees are the mortal enemy of bond fund investors. Since every intermediate-term Treasury fund manager is stuck buying pretty much the same thing, the one who charges the lowest annual operating expenses is all but certain to come out ahead in the long run.

For a high-quality domestic bond fund, I'd never pay more than 0.75% in annual expenses. For a junk bond fund, I would not pay more than a hair over 1%. Some good "flexible" funds that can buy both high-quality and junk bonds, like T. Rowe Price Spectrum Income, Loomis Sayles Bond and Janus Flexible Income, are available for less than 1% and offer one-stop shopping across all areas of the bond market. For example, globetrotting Daniel Fuss, the fixed-income star who runs Loomis Sayles Bond, relentlessly scours the world for cheap paper--issued by anyone from the governments of Manitoba and Poland to RJR Nabisco.

The king of low-cost bond funds is MacKinnon's Vanguard, whose GNMA and Intermediate-Term U.S. Treasury are fine choices for retirement accounts; Vanguard also has a broad line of low-fee municipal bond funds. Other great bargains: American Century-Benham GNMA and Fremont Bond, a little-known fund run by PIMCo's Bill Gross. Both charge annual expenses under 0.7%; the Benham fund ranks in the top fifth of its peers for the past decade, and Fremont (launched in 1993) has returned 8.4% annually over the past three years, beating 96% of its peers.

--RULE THREE: What matters is total return, not yield. In general, a bond fund that is beating its category average by more than two percentage points annually is probably up to some kind of monkeyshines. That's what investors in Piper Jaffray Institutional Government Income found out in 1994, when their fund lost a brutal 28%. It had been the best-performing mortgage fund over the previous five years, with a remarkable mix of high yield and low volatility. But the manager had filled the fund with explosive derivatives that detonated when Alan Greenspan hiked interest rates in early 1994. The indelible lesson: Some bond funds can provide high yield, and some can deliver low risk, but none can do both at the same time. One good safety technique is to look at a fund's annual report or prospectus and check its year-end net asset value per share over at least a five-year period. If net asset value has dropped sharply, let some other poor sucker buy it.

--RULE FOUR: Watch out for gimmicks. Funds with apple-pie names sometimes invest like buccaneers. Alliance North American Government Income sounds like a Treasury fund but now has 49% of its assets in bonds issued by Mexico and Argentina. At year-end 1996, Heartland U.S. Government had 26% of its assets in junk bonds. (This spring, Heartland swore off such stuff.) The Securities and Exchange Commission has recently ruled that funds with descriptive names must invest 80% of their assets as their names would suggest. But that leaves 20% wiggle room, so be on guard.

--RULE FIVE: Put the right funds in the right place. In my opinion, unless you're in the 15% federal tax bracket, you don't want taxable bond funds in your regular accounts. Instead, cache your GNMA, junk or Treasury funds in your IRA, 401(k) or other retirement plan, where the income isn't currently taxable. Conversely, don't put municipal bond funds in a retirement account, where their tax advantage is redundant. You can, and should, own them in a regular taxable account. (Unless you live in a true tax hell like California, Massachusetts or New York, stick with national muni funds, not the single-state or "double-tax-free" variety; the extra expenses you'll usually pay on a single-state fund tend to eat up any tax break they would provide.)

--RULE SIX: Enough is enough. If you can't stand risk, buy only a short-maturity fund (averaging four years or less); if you're more of a gambler, buy an intermediate-maturity portfolio. But it makes no sense to buy both.

In my view, there's little reason to own an investment-grade corporate bond fund; junk funds have better yields, while Treasury funds have lower risk. If your portfolio is very large--$250,000 or up--you may want an international bond fund for some extra diversification.

If you own more than four or five bond funds, you probably own too many; in general, bond prices move more in sync than stock prices do. But if you don't own any, it's time to pick up a couple. When it comes to bonds, nobody does it better than the three stars we've highlighted: Ian MacKinnon of Vanguard, Bill Gross of PIMCo and Dan Fuss of Loomis Sayles. All have regularly delivered returns in the top third of their peers at below-average cost--an unbeatable combination. The table on page 136 has 12 funds that all meet those same tough standards.

The last word: As you should with stock funds too, keep it simple. Don't try to guess the direction of interest rates; that's gambling, not investing. And be a long-term investor, even if you don't buy funds with long maturities; you shouldn't trade your bond funds like there's no tomorrow. Instead, take the title of this year's upcoming James Bond flick as your motto for bond fund investing: Tomorrow Never Dies.

Reporter associate: Derek Gordon