Archive for Sunday, June 20, 2004

Bonds get tricky as rates rise

June 20, 2004

Advertisement

Let's take it as a sure thing: Interest rates are going to rise. What, then, should consumers and investors do to get ready?

Some things are pretty obvious. If you're thinking of getting a new mortgage, you'll probably get a better deal today than six months from now.

Also make it a priority to pay off any credit-card debts. If card rates go up, you'll have to pay more each month just to cover the interest charges, making it harder to whittle the debt.

For investors, the smart moves are not quite as obvious. It's usually a bad idea to try to "time the market" -- to place big bets on changes you think are coming. So if you have a standard investment portfolio of 60 percent stocks, 40 percent bonds, it's probably best to stick with that mix.

But it might pay to re-examine your bonds or bond funds and emphasize safer ones -- those with relatively short times to maturity. In fact, those are much more appealing than most investors realize, even if interest rates are not threatening to go up.

Some background: A new bond typically sells for $1,000, and when the bond matures after a given period, its owner gets that $1,000 back from the company or government entity that first sold the bond. In the meantime, the bond owner earns interest.

But before the bond matures, it may pass from one investor to another at prices set by supply and demand -- more than $1,000, or less.

Bond prices fall as interest rates rise (and rise as rates fall). Pay $1,000 for a bond that "yields" 4 percent interest and you might get only $900 for it next year if newer bonds pay 5 or 6 percent. Long-term bonds are hit especially hard when rates rise, since their owners are stuck with below-market rates for longer.

On the other hand, long-term bonds offer higher interest rates to compensate for that price risk. For the investor, the trick is to find the right balance between risk and return.

Bernstein Investment Research and Management, a New York money manager, recently looked at this tradeoff and concluded that the most attractive bonds have maturities of only two to six years.

The reason is that rates don't go up steadily as maturities lengthen. Instead, they rise quickly as maturities go from three months to two years, and then go up only gradually.

On June 11, for example, three-month Treasury bills yielded about 1.3 percent, two-year notes 2.8 percent, five-year notes 4 percent, 10-year bonds 4.8 percent and 30-year bonds 5.5 percent.

The five-year note is considerably more generous than the three-month bill, but you don't get much more by tying your money up an additional 25 years with a 30-year bond.

The long-term bond is even less appealing when risk is taken into account, since long-term bond prices take a bigger hit when rates rise. Risk goes up only a little as maturity rises from three months to five years, but it rises dramatically with long maturities.

Bernstein identified two "sweet spots" where bond yields are relatively high related to risk.

The first is in short-term bonds -- those with maturities of about two years. These are good for investors who want to protect their principal and use bonds to diversify portfolios that also contain lots of stocks.

With your money tied up for only two years, you won't be hurt much if interest rates rise, and you'll be able to get hold of your money relatively quickly if another investment looks more promising.

The second sweet spot is in bonds maturing in five to six years. The prospect of losing money from falling bond prices is fairly low, though higher than with two-year bonds. And yields are pretty good.

Of course, these intermediate bonds do tie your money up longer. So they're best for investors seeking stable income and higher returns over time, Bernstein says.

Commenting has been disabled for this item.