Brighter economy may dim bonds’ appeal

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After limping out of the Great Recession, seemingly everyone has a stake in seeing the American economy gain traction in 2011.

But it is precisely the prospect of an expanding economy that could harm one notable niche of interest-dependent investors: bond holders.

The problem is that an improving economy would likely mean a pickup in inflation and, ultimately, higher interest rates. Existing bonds, with lower fixed rates, would be less attractive.

Investors would still get their regular interest payments — that’s why bonds are known as a fixed-income investment. But the value of the bond itself would decline, producing a loss if you had to sell before maturity.

That cuts to the central truth about bonds: Bond prices move inversely to yields. If rates start to rise, the value of existing bonds will go down. (Unlike stocks, bonds aren’t traded on exchanges. Generally, you must use a dealer to buy or sell them.)

That’s not to cause panic. Experts aren’t predicting sharply rising interest rates in 2011. Then again, it may not take much to cause problems.

“With interest rates as low as they are, deficits and government borrowing as high as it is, it wouldn’t take much on the inflation front to unleash a real rout in the bond market,” says Greg McBride, Bankrate’s senior financial analyst.

Bill Larkin, fixed-income portfolio manager at Cabot Money Management in Salem, Mass., agrees. Cash “might be the best fixed-income investment possible in 2011,” despite rock-bottom returns on CDs and savings accounts, he says.

Ways to bond

Still, investors desiring a bond’s steady income in 2011 have some risk-limiting options available.

Diversification across many types of bonds will reduce, but not eliminate, interest rate risk. Types of bonds available to investors include corporate bonds, Treasury securities, municipal bonds and agency bonds. Investors can buy individual bonds or they can invest in mutual funds that specialize in them.

Corporate bonds are issued by companies. Essentially, investors lend the company money and receive interest payments for a set number of years. The bonds are redeemed at original face value at maturity. Corporate bonds range from very safe to highly risky.

The U.S. Treasury also issues bonds. Federal debt securities run from very short-term Treasury bills to intermediate Treasury notes of up to 10 years and Treasury bonds that mature in 30 years. They’re backed by the U.S. government and considered to be among the safest investments in the world.

Two other types of bonds are municipal and agency. They’re issued by state and local governments, government agencies and government-sponsored enterprises.

From a financial planning standpoint, interest from corporate bonds, agency bonds and Treasuries is taxable on the federal level. Interest from municipal bonds, on the other hand, is free from federal taxes. This enhances municipal bonds’ appeal.

Holding a bond to maturity negates some interest rate risk because you get your principal back at maturity, no matter if it was worth below face value in the interim. But if inflation has surged in those years, your original investment will have lost purchasing power.

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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