2007 Bond Outlook

Investment-grade U.S. bonds did fare better in 2006 than previous years. But despite decent returns, they still trailed stocks.

In 2003, 2004 and 2005, the Lehman bond index, which covers investment-grade U.S. bonds of all maturities, both government and corporate, finished last in Callan Associates' Periodic Table of Investment Returns, with total returns of 4.1%, 4.3% and 2.4% respectively. For 2006, the Lehman index is up 4.9%, but it clinched another last-place showing because stocks have boomed since midyear. Bonds aren't falling apart, but with yields so low, it's tough to earn capital gains on top of the interest.

So what's a bond investor to do in 2007? Here are some observations and predictions for what to expect this year.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

1. Cash rarely wins. Even when money-market investments yield 5%, as they do now and did in the late 1990s, almost invariably some other bond segment will more than keep up. If you have, say, 25% of your retirement portfolio outside of stocks, don't put it all in a money fund or stable-value account. The exception would be if we suffer another plague of 15% short-term rates as in the early 1980s, but inflation isn't anywhere troubling enough to recreate those dark circumstances.

2. Treasuries fare well against mortgages and mortgage-backed securities. Eight times since 1995, the Lehman Long-Term Treasury index has outpaced the GNMA (Government National Mortgage Association) index, and sometimes substantially. In 2002, the Treasuries posted twice the return of mortgages, 16.8% to 8.7%. There are bond fund managers who see no difference in safety between straight U.S. government debt and mortgages whose principal and interest are guaranteed by Ginnie Mae and Fannie Mae, so they chase the higher yield that results because homebuyers pay more than the Treasury. But mortgage securities are more complicated, what with prepayments and fluctuating yield spreads. If you're a simple Treasury bond or bond-fund loyalist, don't apologize for being stodgy. It's okay.

3. Municipals rock. I know, unless you're rich, retired or living off your savings, who cares about tax-free bonds? Well, since 1999, municipals have placed in the top half of the bond-category rankings every year, finishing as high as second (behind long Treasuries) in 2000. The current ratio of ten-year triple-A-rated municipal yields to Treasury yield is 81%, which is close to its low for the last 52 weeks. It was 89% earlier in 2006, a huge advantage after taxes. This movement means municipals enter the new year appearing to be expensive. But they're not. They're just not as grand of a giveaway as they can be.

4. All-in-one bond market funds make sense. Trying to guess which sliver of the bond universe will be the best in any upcoming year is a challenge. A fund like Vanguard Total Bond Market Index (symbol VBMFX) gets you everything except municipals and junk, which you can add yourself at the margins if you desire. The Vanguard fund's returns would land right about in the midsection of that multicolored chart every year, which is no more and no less than you should expect. Indexing isn't my favorite approach to stocks, where a core-and-satellite approach that uses proven fund managers and leaves room for some individual shares gives you more reward without that much more risk. But it sure makes the baffling world of bonds simple enough to be worthwhile.

Looking back -- and ahead. The biggest bond winner in 2006 shaped up to be high-yield "junk" bonds, whose returns were about 11%. That's close to stocks, which makes sense because junk bonds' performance generally reflects at least, in part, the health and earning power of their sometimes-unstable issuers. As I discussed in a column in September, junk's strong 2006 defied most forecasters' expectations of a lousy year.

Standard & Poor's, which to be fair was far from alone in warning that high-yield was dangerous a year ago, repeats the sentiment for 2007, but in more measured terms, noting, for example, that almost one-third of the junk issuers it follows are under review for a possible credit-rating downgrade. SP thinks corporate bonds will be a treacherous place to be by the second half of this year, junk especially.

Lehman Brothers, in its 2007 outlook, figures that bonds will mostly trade in a narrow range, which suggests another year of 4% or so returns. Since Lehman is pound-the-table bullish on stocks, it bases this judgment mainly on the relative attraction of stocks over bonds.

If you want to diversify a broad-based investment plan and lower risk by using bonds (rather than count on them for income), go with higher-quality corporates and governments, perhaps in an index fund. If you are depending on high portfolio income, the money is in oil and gas trusts, real-estate investments and stocks such as business development companies that offer high dividends.

Somehow, I think we're in for another year where to get really good yields, you need to look at businesses instead of traditional bond issuers. Perhaps the investment firms who publish these beautiful charts need to put royalty trusts in there with the Ginnie Maes and the munis.