The Best Ways to Invest in Bonds

What's a bond investor to do? The credit crunch that began in the subprime-mortgage niche has spread rapidly to investments that seemed undeniably safe just a year ago. The threat of rising defaults looms over everything from mortgage-backed securities to corporate debt. Even tax-free municipal debt looks like less of a sure thing as the financial well-being of bond insurers has come into doubt.

Meanwhile, yields on really safe investments are depressingly low. The average taxable money-market fund yielded a meager 2.3% in mid April, and ten-year Treasuries a criminally low 3.5%. These are not attractive choices.

Inflation is pinching from a third side. As measured by the consumer price index, inflation clocked in at an annual rate of 4.0% for the year through March. And it's only likely to accelerate given low interest rates and an impending injection of cash from the government's economic-stimulus package. If the economy responds strongly to the stimulus, investors and the Federal Reserve could turn their focus to inflation before the year is out. That could prompt a rise in both short- and long-term interest rates.

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

Follow the yields. But you're not condemned to slender yields if you're willing to edge into slightly riskier assets. Municipal bonds, which even without insurance are remarkably safe investments, are screaming buys for investors in taxable accounts.

In mid April, ultra-safe, ten-year general obligation muni bonds (insured and triple-A-rated) yielded 4.1%, free of federal income tax. That's equivalent to 5.6% pretax for an investor in the 28% tax bracket, which beats the pretax yield on ten-year Treasuries by two percentage points. "What's happened in municipal bonds is something we haven't seen in 20 years," says Mark Kiesel, a portfolio manager with Pimco. "They're as cheap as they've ever been."

Invest through a fund unless you're prepared to hold individual bonds until they mature. A fine option is Fidelity Intermediate Municipal Income (symbol FLTMX), which yields 3.4% tax-free. That's equivalent to a taxable 5.2% for an investor in the 35% bracket. If you're buying individual bonds, look for top-rated general obligation issues. A triple-A-rated Massachusetts GO series maturing in 2019 recently yielded 4.0% to maturity, equivalent to a taxable yield of 6.1% for an investor in the 35% tax bracket.

There are also appealing choices for tax-sheltered accounts. "Investment-grade corporate bonds are the sweet spot," says Kathleen Gaffney, who co-manages Loomis Sayles Bond, a Kiplinger 25 fund. She says a glut of high-quality corporate issuers taking advantage of low interest rates has pushed prices down and yields up. Looking for individual corporates? Single-A-rated AT&T bonds maturing in 2018 recently yielded 5.7%.

High-quality mortgage-backed securities are another bargain. Market fears and volatility have pushed these securities to "historic levels of cheapness," says Tom Dugan, co-manager of Dodge & Cox Income (DODIX). His fund has 47% of its assets in government-sponsored mortgages that are cherry-picked for safety and value, in addition to a 35% stake in high-quality corporate bonds. The fund sports a current yield of 5.5%.