Bonds: Smarter Plays for Darker Days

Thinking of Treasuries or other fixed-income plays as the stock market sinks? Here's what to look for

by David Bogoslaw

With equity markets reeling lately—and the Dow Jones industrial average delivering its biggest first-half percentage decline in 38 years—investors have fled stocks for the perceived safety of U.S. Treasury bonds.

There's little incentive these days to own government bonds. The yield on benchmark 10-year notes is down to around 4.0%, and five-year notes are at 3.3%, yields near current inflation levels. Amid concern about rising unemployment, tanking consumer confidence, and growing fear that a U.S. recession has been postponed until the end of 2008, the Federal Reserve may not be able to raise interest rates any time soon, even if inflationary expectations start to spin out of control.

In his July investment outlook, published June 30, bond specialist Bill Gross, a managing director at Pimco (AZ), warned that the federal deficit is likely to top $1 trillion on the next President's watch as the government spends big on a housing-market rescue plan and more comprehensive health-care coverage. That could mean depressed interest rates for a long time to stoke an economic recovery, making the outlook for government bonds pretty bleak.

"You have to think outside the box in this type of environment. Today, you can get in trouble if you're locking in 10 years at [rates under] 4%. I think that's a mistake," says Bill Larkin, a fixed-income portfolio manager at Cabot Money Management in Salem, Mass. The weak dollar is another concern that also promises to keep yields under pressure, he adds.

Those Pricey Treasuries

So, what should investors do? Nothing in the near term, says Michael Wallace, global market strategist at Action Economics. "I wouldn't make any dramatic bets or portfolio shifts ahead of the elections, until people get a sense of what the tax policy is going to look like and the fiscal outlook," he says.

Given how expensive Treasury bonds have become, fixed-income portfolio managers recommend owning a diversified portfolio of debt, including investment-grade corporate bonds and asset-backed securities, such as the packaged pools of mortgages offered by government-sponsored enterprises such as Fannie Mae (FNM). Corporate bonds due to mature within five to 10 years are paying two to three percentage points more than U.S. Treasuries of the same maturities.

"Buying sector spreads [the difference between Treasury and corporate yields] makes sense even though the economy is very weak," since corporate bonds are priced low enough to weather the current economic slowing, says Ken Volpert, head of the taxable bond group at the Vanguard Group in Valley Forge, Pa.

Vanguard offers an Intermediate Term Investment Grade Fund (VFICX) made up of 700 bonds with an average maturity of 6.4 years and a low expense ratio of 0.21%. Vanguard also offers an index fund—the Intermediate Term Bond Index (VBIIX)—that contains 1,000 bonds and has an expense ratio of 0.18%. But since it holds Treasury and government agency bonds as well as corporates, its yield is lower, making it "not as pure of a play on credit" as the actively managed fund, says Volpert.