Investing May 28, 2009, 7:52PM EST

Looking for Yield in All the Safe Places

Bond investors are itching for higher yields but don't want to sacrifice safety. For those willing to take a little more risk, there are some attractive choices

Story Tools

The more they hear about hopeful signs for the economy—and fledgling optimism around equities—the more antsy bond investors are getting about the low yields they're earning on safe assets such as money-market accounts and short-dated U.S. Treasuries.

Frustration with low yields is being exacerbated by fears of future inflation, making bond investors more desperate to find relatively safe places to stow their cash and earn returns that won't be canceled by higher interest rates. Witness the plunge in the price of 10-year Treasury notes on May 27, which pushed the yield to 3.72%, the highest since November and up 120 basis points from two months ago. The next day, yields slid back to 3.64% on revived concerns that optimism about an economic recovery will evaporate.

Higher Rewards Mean Higher Risks

Investment advisers and fixed-income managers are hearing more investors bemoan how small the returns are in their portfolios. There's a nagging question behind the search for higher yields, though: Don't investors need to be willing to give up some safety in exchange?

After all, reward is proportionate to the risk you take, making it infeasible for two different portfolios to carry the same amount of risk yet deliver substantially different levels of return. "It's almost like gravity, you can't get off it," says Frank Armstrong, president of Investor Solutions in Coconut Grove, Fla. "Investors need to accept that we're in a low-interest-rate environment. Anything beyond money-market funds is going to have some kind of risk they may or may not understand."

Equities remain the best place to take risk since investors have never been compensated for taking risk in bonds, such as long-term Treasuries, he says. Pension funds, insurance companies, and other institutional investors, not retail investors, are the natural buyers for long-term Treasuries since they need them to match the duration of their liabilities, he adds.

Long-Term Bonds

George Friedlander, a municipal bond analyst at Citi Smith Barney, a unit of Citigroup (C), thinks that people who are sticking with taxable money-market funds or short-term CDs with returns around 0.2% "are leaving yield on the table for no significant market risk resulting from inflation." He strongly believes that inflation doesn't pose a threat for the next three to five years.

That should make it less risky for investors to buy bonds further out on the yield curve than they normally might feel comfortable doing. If you buy a bond that matures in eight years, for example, you'd really be risking an increase in rates for the last three of the eight years, he says. Friedlander thinks rates are more likely to rise for reasons other than inflation, either because the Fed removes quantitative easing by no longer buying government and corporate bonds from the banks or because investor appetite for risk increases as the economy improves.

Many economists and investment managers who believe a recovery will be modest at best expect inflation to be quite tame over the next several years, says Kim Rupert, managing director of fixed-income analysis at Action Economics. A slower-than-normal recovery may reduce the need for the Fed to raise interest rates, but that doesn't mean Bernanke & Co. won't allow rates to simply drift higher, she says.

"If investors start to perceive that inflation will be a problem and that Fed buybacks [of Treasuries] won't be aggressive and supply will swamp demand from all sources, then rates will naturally drift higher," she says. "That will be exacerbated by the amount of stimulus in the system."

Municipal Bonds

Municipal-bond yields have dropped sharply since their December highs but are still above their historic levels, which have been 85% to 90% of comparable-maturity Treasury yields.