Why Bond Investors Are in a Bind

The inverted yield curve is about to throw you a curve. For those of you who aren't bond geeks, an inverted curve means shorter-term bonds yield more than ones with longer maturities. This situation defies common sense -- why be paid more to hold bonds for a shorter length of time? Yet it happens when the Federal Reserve Board pegs short-term rates high to forestall inflation at the same time that market forces hold down long-term rates. With signs that the economy is weakening, the Fed will most likely begin cutting short-term rates by the middle of 2007. Meanwhile, the yield on ten-year Treasuries, at an abnormally low 4.7% in mid November, should return to and probably top 5%. Voilagrave;! No inversion.

But until short- and long-term rates resume their normal relationship, you face a dilemma. With yields at 5% or so, do you grab Treasury bills, money-market funds and the like, knowing the yield will fall as the Fed cuts short-term rates? You won't lose principal, but your income will decline. Or do you resign yourself to losing a little money in individual bonds and bond funds when long-term rates rise (although probably not enough to result in negative total returns for the year)?

Five-year solution

Certificates of deposit remain a good place to park your money early in 2007, especially if you're willing to shop around rather than settle for what the neighborhood bank is paying. "If your goal is to get the most return and you're indifferent about the time horizon, five-year CDs are the place to be," says Greg McBride, of Bankrate.com. The top-paying five-year CD recently yielded 5.5%, well above the national average of 4.1% (see current CD yields).

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Better yet, invest now in a high-yielding money-market fund. Later in 2007, when longer-term bond yields rise above 5% and short-term yields fall below that level, switch horses and buy five-year CDs or bonds with maturities of five to ten years. "Intermediate-term bonds may not give you the yields you're looking for right now, but they'll lock you into a more attractive rate for the future," says Marilyn Cohen, president of Envision Capital Management, a Los Angeles bond advisory firm.

An excellent medium-maturity fund is Dodge Cox Income (symbol DODIX; 800-621-3979). The fund, which holds a mix of high-quality corporates, Treasuries, and mortgage debt, returned an annualized 5% over the past five years to November 1, and currently yields 4.9%.

For investors in a high tax bracket, it makes a lot of sense to put the bulk of their bond money in a solid, tax-free municipal-bond fund. Consider Fidelity Intermediate Municipal Income (FLTMX; 800-544-8544). It yields 3.8% -- the equivalent of a taxable 5.7% yield for an investor in the 33% federal tax bracket -- and returned an annualized 4% over the past five years.

If you prefer individual munis, it's hard to go wrong with a general obligation bond from a strong issuer. For example, a New York City GO with a coupon of 5% and a maturity date of June 1, 2011, rated AA- by Standard Poor's, recently yielded 3.7% to maturity. That's a taxable equivalent of 5.5% for a 33%-bracket taxpayer.

High-yield bonds led the way in '06, returning 8.8% on average in the year's first ten months. But junk is now relatively expensive: The average high-yield bond pays a little over 3% more than ten-year Treasuries -- and the category usually lags when the economy sags. "It's been a great run, but I don't know what could lift high-yields any higher," says Kim Daifotis, chief of fixed income for Charles Schwab Investment Management.