Bond Bonus

Will fixed-income vehicles continue to produce solid returns?

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This year, investors have learned the value of diversification. Stocks stumbled, as they do every few years. In the beginning of the fourth quarter of 2000, the Dow Jones industrials were down more than 6%; other major market averages also were under water. Bonds are supposed to stabilize a portfolio, and that’s exactly what they did. The Lehman Bros. Long Treasury Bond Index was up nearly 12% for the year. Municipal and corporate bonds showed smaller but solid gains.

The good news is that gains from the bonds in your portfolio offset your losses from stocks. The bad news is that when bond prices rise, yields fall. Some experts see the brightest prospects in a dim corner of the bond market.

Corporate bonds. “The 10-year spot on the corporate yield curve is a favorable place to be now,” says Tom Marthaler, manager of the Alleghany/Chicago Trust Bond Fund (CHTBX). Recently, 10-year corporate bonds rated A (AAA is the highest rating) were yielding close to 8%.

“Current spreads are enormous by historic standards,” says Sam Paddison, senior vice president of specialty fixed-income in the Philadelphia office of First Union Capital Group. That is, yields for these types of bonds are extremely high compared with Treasury bonds. Yet those

nearly 8% yields seem fairly safe. As long as the economy keeps rolling along without a recession-the current forecast-there’s little risk of A-rated companies running into financial trouble and defaulting on their bonds.

Investors interested in these bonds may prefer mutual funds rather than individual issues. According to Morningstar Inc., located in Chicago, Metropolitan West Total Return Bond Fund (MWTRX) is a five-star fund holding those types of bonds.

Tax-exempt bonds. William Stevens, portfolio manager of the Montgomery Short Duration Bond Fund (MWSGX), notes, “There’s a lot of demand for 10-year bonds, which drives prices up and yields down. If you go out to the 11- and 15-year range in the muni market, you’ll get more yield than you’d get with a 10-year bond, yet there’s not much more risk for buy-and-hold investors.” For state as well as federal exemptions, investors may want to buy locally issued munis, and hold those bonds until they mature.

High-yield (junk) bonds. These bonds have been so depressed for two years that yields are comparatively high: The average junk bond fund now pays more than 10%. Nevertheless, “There is no way to know when the problems in the credit world of high-yield bonds will be over,” says Richard Ciccarone, co-director of fixed-income investments at Van Kampen Funds in Oakbrook Terrace, Illinois. “Moody’s predicted default rate for 2001 is 8% to 9%, about twice the level of 2000.”

An economic slowdown may put pressure on issuers of junk bonds; these instruments tend to lack the financial strength of their A-rated cousins. If you’re tempted by those double-digit yields, the safest way to pursue these bonds is through a diversified mutual fund. Eaton Vance Income Fund of Boston (EVIBX) and Vanguard High-Yield Corporate Bond Fund (VWEHX) have received the highest ratings from Morningstar.