2011 Interest Rate Forecast
Rate forecast
Brighter economy may dim bonds' appeal

Another risk reduction strategy is buying bonds with maturities between five and 10 years, says Donald Cummings Jr., managing partner at Blue Haven Capital in Geneva, Ill.

With that time range "the interest rates are high enough that if we went up a couple percent in two years or up 4 percent in yield over the next four years, you'd just about break even" between income payments on the one hand and the drop in the bond's value of the other, he says.

Mutual fund investors must be cautious, though. Many bond funds hold long-term maturities of more than 10, 15 or 20 years. Longer-term bonds pay higher interest, but their prices will be impacted far worse by any surge in interest rates.

Perceived risk, real return?

While the recession has been terrible for the finances of some beleaguered state and local governments, those problems have produced a relatively lucrative opportunity for municipal bond buyers.

With the foreclosure crisis there is a distinct, though extremely unlikely, possibility of municipalities defaulting on their debt. The silver lining: higher yields to counterbalance the greater risk. In many cases, the perception of risk rather than actual danger is pushing yields up.

Larkin says many muni bonds have yields up to three times greater than comparable Treasuries. The safest munis are sporting yields similar to blue-chip corporations, in contrast to historic patterns.

"It's not often you are able to buy higher credit, less risk paper for higher yield," says Cummings. Larkins adds that, to further hedge against possible default, "look for (bonds that finance) critical services that society can't live without -- water, sewer, schools in good towns."

Assisting consumers, ratings agencies like Standard & Poor's, Moody's and Fitch Ratings evaluate the credit quality of bond issuers and assign a rating. A higher rating indicates enhanced creditworthiness.

As with corporate bond funds, municipal bond fund investors should stick to short to intermediate funds, focusing on maturities between three and seven years.

Bankrate has a comprehensive analysis of where all sorts of interest rates are likely headed in 2011, and how these moves will affect you. Go to 2011 Interest Rate Forecast to view the full report.

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