Bonds to the Rescue

Stock investors are dazed, bloodied and terrified. Bond owners aren't exactly celebrating, but they're in much better shape. Yet it's not too late to buy bonds. You just have to choose them carefully.

Bonds remain attractive even though the debt markets are as discombobulated as the stock exchanges. With the demise of Lehman Brothers and with other financial institutions scrambling to strengthen their balance sheets, even some investment-grade bonds are having trouble attracting buyers. Municipal bonds are under some duress, too, because of concerns that local governments may have invested in debt instruments that have lost a significant amount of value.

Bond-rating agencies aren't helping matters. Smarting from criticism about their failure to diagnose the original subprime-mortgage mess, the raters are aggressively downgrading the credit standing of financial companies and municipalities. Accountants are insisting that holders of questionable loans and mortgages -- meaning just about all banks and many mutual funds -- mark down the value of these assets more deeply.

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As a result of all the fear, uncertainty and doubt, investors have been stampeding into Treasury bonds, which are by miles still the most trusted name in savings. This has pushed down Treasury yields to preposterous levels. For example, the ten-year Treasury bond closed September 17 at 3.38%. That's below the current inflation rate of about 5% (although it could be the bond market's way of signaling that inflation is likely to head down as global economies weaken). The superlow yield also stands in direct contravention of the conventional wisdom that greater supply -- in this case, the government bonds needed to fund Uncle Sam's bailout spree -- should lead to lower bond prices and, hence, higher yields.

In a logical world, this would be a great time to bet against bonds (nowadays, the average investor can do that easily enough by buying a mutual fund or exchange-traded fund that is designed to move inversely with Treasury prices). But these are not logical times.

I'll assume that most of you prefer something a bit tamer. What looks good? For starters, take a look at U.S. corporate bonds outside the financial sector, IOUs issued by the likes of Time Warner, Verizon and Wal-Mart Stores. "This is the best part of the bond market, where the value is," says Kathleen Gaffney, co-manager of Loomis-Sayles Bond fund, a member of the Kiplinger 25.

You can find gobs of good bonds. Ask your investment adviser (if you have one) or go to the bond listings at a broker such as Fidelity or Schwab or a general Web site, such as www.investinginbonds.com. For example, Wal-Mart has an issue that comes with a 6.2% coupon, matures in 2038 and offers protection against call, or early redemption. In mid-August, before the deluge of bad news, the bond traded to yield 6.1%. It closed September 17 at a yield 6.2%, meaning that its value had remained virtually unchanged during this period of maximum financial stress. Standard & Poor's gives Wal-Mart a solid AA rating.

This isn't to say that all corporate bonds are timely. Think it's worth buying a 30-year bond from General Electric, which has a big financial component or JP Morgan Chase for a shot at a 6.5% yield? I don't. You could get burned by a ratings downgrade or a panicky selloff stemming from a rumor about the company's solvency. "There's a dichotomy between industrials and financials," says former bond trader Scott Noyes, now owner of Noyes Capital Management in New Vernon, N.J. "Industrial bonds are cheap. Financial bonds, no one wants them, investors don't trust the rating agencies. I'd take a Coca-Cola bond any time, though."

What else looks right? Look at municipals, but selectively. The decline in Treasury yields enhances the attractiveness of tax-exempt bonds. A state general obligation bond, one supported by general tax revenues, offers 3.64% for ten years, 4.48% for 20, and 4.66% for 30. That's more than Treasuries pay even before taking into consideration that interest from most munis is exempt from federal taxes. And if income-tax rates rise at some point in the future, the tax-exempt feature of munis should make the bonds even more valuable. For the most part, municipals are removed from the mess on Wall Street, although there may be instances of a state or local government having made unwise investments in debt issued by Lehman or American International Group.

Some bond gurus urge caution. T. J. Marta, the bond strategist for RBC Capital Markets, is seeing "some crazy, perverse price action" from his firm's trading desk. That's not reassuring. So he suggests sticking with the simple and the obvious. He recommends three-month to two-year Treasuries "until the forest fires burn out."

Funds or individual bonds? Funds, of course, are convenient and offer diversification. But diversification cuts two ways. With municipals, you want a wide reach now, so that if the Western West Virginia Water Authority is found to have frittered away all its money in AIG swaptions or what-have-you, you'll barely notice. Unless you're limiting yourself to state general obligation bonds, you probably should buy a large tax-exempt fund with a proven record, hundreds of holdings and low expenses.

If you're investing in corporates, however, a broad-based portfolio may get you more financial-company bonds than you want. So if you're thinking of taking $10,000 or so out of a money-market fund or using the proceeds from a stock sale to land a 6% yield, buy a high-grade issue that can't be called for several years. Bond funds are convenient, but they're not always the way to go when the market is turbulent.