Hanging Onto Safety With Bonds

Who says bonds are boring - stuffy, low-earning, plain-vanilla investments for the ultraconservative?

Bonds are suddenly in.

Those things your grandparents tucked away and trusted have become some of the hottest-selling of investments of 1998, as interest rates head south and bond prices move north.

Americans plowed more than $47 billion into bond mutual funds alone last year, more than the total for the three previous years combined. And many investors buy directly, creating their own "ladder" of bonds climbing from from short to long durations.

Analysts see three reasons for the bond binge:

* Falling inflation. Prices are rising at the lowest rate - less than 2 percent last year - since the 1950s. Bonds typically do well in a low-inflation environment.

* Lower interest rates. As rates fall, bond prices zoom upward in an inverse relationship. That's what happened in a big way last year, and many analysts see the trend continuing.

* Shrinking faith in stocks. With equity prices high and slower growth ahead for corporate profits, bonds look increasingly attractive. In effect, stock investors don't see enough potential reward ahead to offset stocks' higher risk.

Many analysts say the easy money on bonds was made in 1997, when the rate on the 30-year Treasury bond fell from more than 6.7 percent (and higher midyear) to about 5.9 percent. A holder of a 30-year bond saw its price jump sharply, making for a total return of about 15 percent, according to Technical Data Company in New York.

But the move isn't over, predicts Al Goldman, chief economist at A.G. Edwards in St. Louis. He sees 30-year Treasury rates hitting 5 percent later in the year.

Rao Chalasani, chief investment strategist at Everen Securities in Chicago, sees rates drifting to 5.5 percent "over the near term," from current levels near 6 percent. The positive factors that boosted bonds late last year are still in place, he says, but may now be reflected in current yields.

Track record

Historically, stocks have outperformed bonds. From 1926 through 1997, large-company stocks returned 11 percent annually, on average, versus 5.2 percent for long-term Treasury bonds, according to Ibbotson Associates in Chicago.

For short periods, however, bonds have occasionally been top gun. That happened in the late 1960s, for example.

Many experts believe we are now in another historical period giving a special kick to bonds. For the second half of last year, Treasuries outperformed most US diversified stock funds.

Most investment strategists say people should have at least part of their nest egg in bonds, ranging from 10 to 40 percent, depending on how long they have until retirement and their ability to absorb market risk.

But not all analysts buy into the current euphoria.

"I think bond prices may be topping over the next few weeks," says Phil Rettew, an analyst at Merrill Lynch in New York. The current demand stems less from potential gains than from a "flight to safety" in a turbulent climate.

Robert Barbera, chief economist at Hoenig & Co., argues that the current consensus scenario - falling interest rates, low inflation - may not exactly play out.

Mortgage refinancing, for example, is at an all-time high and should put more spending money in American pockets.

If the Asian currency crisis subsides, and the US economy does not dramatically slow, then stocks could again look attractive. Treasuries might also give up some recent gains, as the "flight to quality," from risky Asian markets to safe US bonds, reverses direction.

Attractive types of bonds

Bonds now considered the best investments include:

US Treasury issues. They are ultrasafe, backed by the US government. And prices are bolstered by shrinking supply. With the federal deficit disappearing, Uncle Sam will be issuing fewer bonds. There is even some speculation that the Treasury might stop issuing 30-year bonds.

The top government-bond mutual funds of late are four American Century-Benham Target Maturity funds (800-345-2021), designed for people who expect to need the money in 2010, 2015, 2020, or 2025. These and top mutual funds in other categories are shown in the nearby chart. Notice how the long-term target portfolios outperformed the short ones. The longer the duration of a bond, the more responsive its price is to changes in long-term interest rates, whether up or down.

Carefully selected municipal bonds. While city and local-government debt is not as safe as Treasuries, defaults have been remarkably limited. Individuals in high tax brackets may come out ahead owning munis, which are free of federal taxes (and state ones, typically, if the bonds are issued in your home state). Treasuries are free of state taxes only.

High-yield bonds. They pay more, but carry higher risk of default - that's why they're called "junk bonds." Since diversification spreads this risk, most people should invest in these through mutual funds.

Buying bonds is relatively easy. You can acquire them through a broker - for a commission - or buy mutual funds. With mutual funds, note that there is no guaranteed return of principal, as with an individual bond held to maturity. When you sell shares in a fund, they can be worth more or less than when you bought them.