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When Corporate Bonds Hit The Roof


Personal Business: INVESTING

WHEN CORPORATE BONDS HIT THE ROOF

With the bond market rallying and with interest rates sinking to levels not seen since last year, you may wonder if there's a way to capture some extra yield. The traditional method is to invest in corporate debt and pick up a few extra points over Treasuries. Trouble is, corporate bonds have been in especially high demand and are trading at historically pricey levels--barely half a percentage point above Treasury securities.

Should you steer clear of corporates entirely? No. Daniel Fuss, manager of Loomis Sayles and Managers bond funds and the nation's dean of corporate bond pickers, recalls even higher prices back in the 1960s. He thinks the current high valuation of corporate bonds relative to Treasuries, given the benign economic and political outlook, could persist "for a heckuva lot longer."

So what do you do? Here's the trick: If you reach for the extra yield that corporate bond funds promise, pick a fund with a habit of sticking stubbornly to targets for its portfolio's average credit quality. In other words, don't buy a fund if it has steadily held bonds averaging AA ratings and now is taking bigger risks with bonds of lower quality. Stooping to conquer doesn't work once prices have already been bid up because you're buying less valuable goods at higher prices.

Getting a corporate bond fund's current credit profile from fund companies takes no more than a toll-free call. But they don't make historical records readily available. BUSINESS WEEK asked Morningstar to sift through its database and help pinpoint a few solid investment choices among some 445 possibilities. Beyond focusing on consistency in credit quality, we also asked Morningstar to eliminate funds that charge loads, demand initial investments higher than $10,000, or are closed to new accounts. In the end, we narrowed the group to four choices, one in each of the following categories: long-term (maturities of 10 years or more); intermediate (4 to 10 years); short-term (1 to 4 years); and ultrashort (a year or less).

When you're thinking about where to place new bond-market investments, don't forget that the more long-term a bond fund's holdings are, the more sensitive the fund will be to interest-rate swings. That's great if rates keep dropping. Just keep in mind that if rates head north again, long-term funds will suffer the most, and ultrashort funds the least. Remember, too, that if your combined state and federal tax rate is 28% or more, and this part of your bond investment isn't sheltered from current taxes in a retirement account, you'll likely do better buying a municipal bond fund.

LOW EXPENSES. Among the long-term funds, Vanguard Fixed-Income Long-Term Corporate stands out, and not just because it enjoys Vanguard Group's usual edge of low expenses--in this case, just $28 annually on a $10,000 investment, vs. an average of $110. The fund also shows superior consistency and performance. Run since early 1994 by Earl McEvoy, the fund has steadily invested in bonds with an average credit rating of A, while wringing out an annual average total return of 8.73% over the past five years. McEvoy says he doesn't see interest rates falling a lot further this year, and so now he's lowering the fund's average maturity a bit.

In the intermediate-term category, Harbor Bond overcame keen competition from Strong Corporate Bond (800 368-1030) and SteinRoe Income (800 338-2550) funds, each of which has made more money for investors over the past five years. But Harbor, run by William Gross of Pacific Investment Management (box), accepted less exposure to the risk of higher interest rates and bought higher-quality bonds. In addition, the fund's expenses are lower ($70 a year on a $10,000 investment).

One way Gross has squeezed more than 8% a year out of an AA portfolio is by adding a larger-than-typical mix of mortgage bonds and a smattering of foreign bonds to Harbor's corporate issues. Mortgage and foreign bonds present their own risks, including currency volatility, but managing this mix is Gross's specialty.

The appearance of Fidelity Intermediate Bond fund in the forefront of the short-term group comes as a surprise. This fund, despite its name, has characteristics more akin to Morningstar's short-term group. Within the group, it is more sensitive to interest-rate fluctuations than is typical. This will continue to buoy the fund, which has expenses of only $71 a year on a $10,000 investment, if rates keep falling. But when rates turn around, this fund will suffer more than its peers, as it did back in 1994, when interest rates surged.

That said, portfolio manager Christine Thompson isn't aiming to make money with bets on interest rates. Instead, she's carefully keeping the portfolio's interest-rate sensitivity steady. She recognizes that corporates are richly priced now, so she is growing more defensive in her choices. But she doesn't see that part of the market crashing. "If I thought it would happen soon, I wouldn't own corporates at all," says Thompson.

There are few differences between a money-market fund and an ultrashort-term corporate bond fund. Ultrashorts don't aim to keep a stable, $1-per-share net asset value. If you're willing to accept less return for a bit more predictable performance, a money fund is fine for the cash you need to keep within easy reach. With its low fees and recent yield of 5.35%, Vanguard's Prime Portfolio (800 662-7447) is one good choice.

But if you can take a slight risk with your very short-term funds, then you might think about Strong Advantage. It has built a steady record of nimbly handling its lower-quality, BBB bond portfolio, which has produced an average annual return of 6.58% with low volatility.

SHREWD PICKS. Managers Jeffrey Koch and Lyle Fitterer aim to fit in a niche: buying bonds with maturities that are too long for money-market funds but too short for longer-term bond managers. They also target floating-rate bonds of banks such as Citicorp, and they'll even buy higher-grade junk bonds they expect will be upgraded, such as some News Corp. issues. "We want to be able to go through one of the worst bond markets on record and beat money-market funds," Koch says, noting that he came close in 1994, with a total return of 3.6%.

To do that, Koch had to pick his bonds shrewdly and accept some extra risk. You can avoid all credit worries by buying shares in funds that invest solely in U.S. Treasury bonds. But over time, you'll do better by accepting the minimal risks that good-quality corporate bond funds entail.By Robert Barker EDITED BY AMY DUNKINReturn to top


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