It's Time to Buy Bonds

Warren Buffett, Knight Kiplinger and other seasoned souls say they're buying stocks again. I think it's too early to declare the end of the bear market, but the week of October 13 was encouraging. So now I'll say something unexpected: It's also time to shop for bonds.

I know that may sound weird. Don't investors raise money to return to stocks by selling safer stuff, including bonds? Well, in normal times and normal bear markets, they do. But this year's twin disasters in stocks and bonds are unlike any since Barack Obama was in junior high and John McCain was a freshly released POW.

That's right: 1973-74 is the last time U.S. stocks and bonds (not counting Treasuries) have been hammered so ferociously simultaneously. Through the third week of October, every segment of the U.S. and international bond markets except Treasury debt showed negative total returns (interest income minus price changes).

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Here are some sad year-to-date numbers as of October 20 from the Lehman bond indexes (now from Barclays, but still bearing the Lehman brand): municipal bonds, down 9%; long-term corporates, down 24%; intermediate-term corporates, down 9%; emerging-markets bonds, down 20%.

But there are some positive signs in the bond market. New municipals, sales of which virtually ceased in September, are starting to come to market again. The state of California had to turn away buyers in mid October when it sold $5 billion of short-term tax-free debt.

The spread, or gap, between Treasury yields and the yield of high-grade corporate bonds of equal maturities is narrowing. What that's saying is that the parties who represent the nebula called "the bond market" see less risk in owning corporate and municipal debt as opposed to Treasuries than they did a week or two before. Fear of high inflation -- another threat to the value of bonds because it implies that interest rates are headed higher -- is vanishing because of plunging prices for oil, grains and industrial metals. That, in turn, reduces the appeal of competing investments, such as oil-and-gas income trusts.

I am not suggesting that every kind of bond is a fabulous buy or that bonds overall will do better than stocks for the rest of 2008. But I do think bonds will earn positive total returns over the next quarter or two. So if you're less than thrilled with Treasury bills and money-market funds paying 1%, or certificates of deposit with rates in the 2s, it's okay to put some savings into intermediate-term bonds that pay 4% or 5%, or in municipal bonds, which can pay tax-equivalent returns in the 8% range.

The sweet spots are corporates rated A+ or better and, in the muni area, similarly rated general obligation or essential-service bonds (for water and sewer projects, for example) from states and healthy cities and counties. Stay away from junk, most foreign bonds, and municipals that get their revenue from airports or shaky business ventures such as -- and I'm not making this up -- New Jersey casinos. Treasury bonds still do not pay enough interest to make sense at current prices.

If you prefer funds, invest in plain, transparent, low-cost funds. Bond funds occasionally employ opaque trading strategies involving hedges and derivatives. Many of these have performed disastrously in 2008. So look at a fund's list of holdings and steer clear if you find things in there that even a financial adviser can't explain.

Here is a closer look at my two favorite bond categories.

High-grade corporates. There aren't many new issues because many companies are putting off borrowing until bond yields come down. But there are plenty of good deals in the secondary market. Several bond-fund managers tell me they make a clear distinction between buying a bond from an industrial icon such as Caterpillar or Wal-Mart (yes) and those issued by a bank or an auto finance company (no). You can get current listings from your brokerage firm -- say Schwab or Fidelity -- or www.investinginbonds.com.

It's a fact of life that when a broker buys a bond from an individual, the broker pays several cents on the dollar less than the price it charges when you buy the bond. But as annoying as that seems if you're fixing to trade in and out, it shouldn't matter if you plan to keep the bond for a long time.

Instead, focus on the terms you get. If you can buy something like a 20-year Johnson & Johnson bond for a current yield of 6.3% and a yield to maturity of 6.0%, why worry about a few commission dollars? You may say that J&J stock, which yields 3%, should return more than 6% over any long holding period. Well, it's not an either-or proposition. Buy J&J shares and the bonds; your portfolio probably has room for both. Or, if you're looking for a short-term parking place that pays as you wait, check out Berkshire Hathaway's five-year notes, which have a current yield of 4.7% and a yield to maturity of 4.9%.

Municipal bonds are, if anything, even more of a deal -- 5% yields are common. That's the equivalent of 5.9% for a taxpayer in the 28% federal tax bracket and 7.7% for someone in the top 35% bracket. Some tax-exempt bond managers tell me they feel slighted by world financial markets, which curiously came to regard the likes of Massachusetts and New York City as little different than Wachovia and Citigroup -- despite the ability of muni issuers to tax, put liens on delinquent citizens and back up their debts further by placing Treasury bonds in escrow (a practice known as pre-refunding).

Hedge funds, which have been blamed for increasing volatility throughout the financial world, have roiled the muni market, too. Hedge funds bought munis for their favorable yields (I can't fault them for seeing opportunity), then dumped them all summer to raise cash. The disappearance of some investment banks made it harder for hedge funds to find buyers, helping to drive up tax-free yields.

But as the credit crunch eases and fewer hedge funds are left to sell in a panic, you'll see an ever sweeter buying opportunity. Go to the Schwab tax-free bond marketplace and scroll through what's on sale. It'll remind you of Macy's after Christmas.

I recommend that you ask a brokerage rep or a financial adviser about specific features of individual bonds -- for example, call provisions, bond insurance and whether the bond is pre-refunded. Most important, don't be afraid to buy individual bonds even if you're not a millionaire. Books and Web sites that say you must be rich to own individual, high-quality bonds are repeating a dated message that's been rendered obsolete by the advent of inexpensive online investing and real-time price information.

AFTERWORD

In May's Cash in Hand I questioned the value of "black-box" bond funds that claim they can add extra return without adding appreciable risk by using inexplicable derivatives strategies. Since May 14, when I wrote the piece, through October 20, the four named funds -- Putnam Diversified Income (symbol PDINX), Diamond Hill Strategic Income (DSIAX), Transamerica Flexible Income (IFLBX) and Pimco Diversified Income (PDVAX) -- have crashed, losing 17.4%, on average. Over that same period, an iShares exchange-traded fund based on the Lehman aggregate bond index lost 2.9%. Their collapse buttresses a key point about bond investing that I make frequently: Keep it simple!