In This Not-So-Golden Year for Bonds, There Are Gems to Mine

Will bonds be king in 1997?

Not if you believe, as many do, that the U.S. economy will continue growing through much of 1997.

Just look at last year. As the economy advanced in 1996, yields rose on U.S. Treasury bonds from their lows early in the year.

The yield on five-year Treasury notes was 5.38% a year ago. It ended 1996 at 6.21%. So note holders suffered a principal loss that negated much of their interest earnings.

This year promises to be a continuation of economic expansion, which usually brings higher interest rates, which keep a lid on bond prices. Still, the prediction of rates is always a roll of the dice. Some experts see steady or lower rates this year. But conventional wisdom is that rates will rise modestly, and thus the value of existing bonds will drop some.

“I can’t see much upside to bonds in ‘97,” said Laura Tarbox, a certified financial planner in Newport Beach. “I see a lot more possibility of rates going up, which means investors would lose. The yields are so low there’s not a lot of upside.”

Still, most investors do not buy bonds to profit from market interest rate moves. Rather, they seek to stabilize and diversify their portfolio--or protect themselves from a serious recession that could crush their stock holdings. And for those, there are plenty of bright jewels in the fixed-income universe.

Inflation index bonds. A completely new bond animal is being called the biggest thing to hit the market since zero coupon bonds premiered in 1985. Investors might want to give them a look.

The inflation-proof bonds will be sold early in the year (the original Jan. 15 launch has been delayed to Jan. 29) in 10-year maturities carrying an expected annual interest rate of 3% or 4%. That’s far below a traditional 10-year Treasury note, which is currently yielding about 6.42%.

The principal on the bonds, however, will grow to match any rise in consumer inflation each year. That protects investors by guaranteeing a positive real return. It also eliminates a major risk with traditional fixed-rate bonds: the loss of purchasing power.

Tim Kochis, a certified financial planner in San Francisco, said these bonds are one of the best plays for investors with an important short-term need such as college funding.

“While as citizens we might have some skepticism about whether it’s good to shift the risk of inflation to the U.S. Treasury--read taxpayers--and away from investors, for some investors it’s a good investment,” Kochis said.

The bonds, which will be sold in denominations as small as $1,000, are designed to keep government financing costs low, he said. They have been sold by other countries such as Britain, Canada and Australia. Some analysts say the bonds will help discourage the government from allowing inflation to rise too fast.

“Many people say this is the worst possible time to issue inflation index bonds, as inflation has only one way to go--up,” Kochis said. “But that’s why they are good buys for some investors.”

Small investors can buy the bonds directly with no service charges or fees just by calling the nearest Federal Reserve bank or by calling (202) 874-4000. Investors can also buy bonds through their broker. In addition, they can invest in one of the inflation index bond mutual funds being created. One such fund is being formed by American Century (formerly Twentieth Century/Benham). Minimum investment is $2,500.

High-yield bonds. One of the best opportunities for this year--as was the case last year--could well be in high-yield corporate bonds, better known as junk bonds. These are a good bet if an investor has already accumulated assets in the basic categories, such as large and small U.S. stocks, foreign stocks and government bonds.

There are two big reasons why junk bonds are good bets for 1997. First, because of their relatively high yields, their prices are less sensitive to interest rate moves.

Second, if the economy continues to strengthen slowly, it could help improve the balance sheets of companies that issued junk bonds, which could, in turn, boost credit ratings on the bonds.

Richard Moran, a certified financial planner in Palos Verdes Estates, recommends the Putnam High Yield Advantage fund, recently yielding more than 7.7% annualized. He likes it because of Putnam’s expertise in stock picking; in the high-yield area, what’s behind a company’s balance sheet is crucial, Moran notes.

Jennifer Leichter, senior portfolio manager of Putnam High Yield Trust, said that even a slow-growth environment could help the high-yield sector, as a lot of companies will not be in the market with more debt in 1997. That could make existing junk issues more highly sought-after.

Investors should remember that the high-yield market is a seasonal one since the largest institutional investor in high-yield tends to be insurance companies, Leichter said. Those firms typically reallocate their portfolios early in the year, which can cause junk bond values to move up, or down, quickly in January.

Northeast Investors Trust (five-year average annual return: 15.64% and a yield of about 9%) is the pick of Norman Boone, a certified financial planner in San Francisco. Started in 1950 with an emphasis on lower-rated or nonrated bonds, the fund has had steady and savvy management for 36 years, he said.

Global bonds. Another good diversification move in 1997 could be bonds from companies and countries from emerging markets. This sector posted one of its best years ever in 1996, even outperforming U.S. bonds.

However, some specialists are predicting that sharp declines in foreign interest rates, which helped boost the value of foreign bond funds in 1996, may be over. And this sector carries significant risk from currency changes as well as interest rate changes.

Still, one fund that analysts are touting for 1997 is Morgan Stanley Emerging Markets Debt, a closed-end fund with shares currently priced at a discount and yielding about 10%. Another good fund, according to planners, is Templeton Global Income, a closed-end fund recently selling at a 16% discount from net asset value with a current yield of about 8.1%.

“Main Street” bonds. Those looking for something a little closer to home might consider a tax-free municipal bond fund. Californians in the 28% tax bracket and up might find attractive returns in short-term muni bonds maturing in five years.

“Munis make a lot of sense, especially for those investors a little concerned about the highs the [stock] market is reaching,” said Mark Wright, a fixed-income analyst at fund tracker Morningstar Inc.

The Vanguard California Tax-Free Insured Intermediate fund is a popular bet because of its low expense ratio. While the group of California muni funds as a whole has a 1.2% expense ratio, the Vanguard fund posted a 0.2% expense ratio, Wright said. And the fund has yielded 4.7% annualized recently, which translates into an 8.87% return for California investors in the top tax brackets, he said.

For those looking for a little more return and risk in munis, there are several good options. Wright recommends Benham California Municipal High-Yield Fund because of its competent management and reasonable expense ratio of 0.51%. The fund recently yielded more than 5.3%, annualized.

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Between Sixes and Sevens

Although investors watched the benchmark 30-year Treasury bond yield all year, reacting to its every move, the yield stayed within a 1-percentage-point range for most of 1996. Thirty-year T-bond yield, weekly loses and Dec. 31:

Dec. 29, 1995: 5.94%

Dec. 31, 1996: 6.64%

* Source: Associated Press