Fixed-income investors find a happy medium

A weakening economy could make intermediate bond funds more attractive.

With inflationary forces waning and interest rates starting to ease, risk-averse investors face a quandary.

Do they keep most of their cash parked in money-market funds, or do they latch onto the resurgent bond market in hopes of gaining modestly higher returns? With many money- market funds yielding close to 5 percent, it's tempting to stand pat, says Eric Jacobson a bond analyst for Morningstar in Chicago. "Yields on high-grade bonds with longer maturities don't look all that rewarding by comparison," he says.

Since the yield on 10-year Treasury bonds reached a four-year high of 5.25 percent in late June, it has slipped to about 4.7 percent. By contrast, short-term interest rates, including money-market yields, have remained relatively firm over the summer.

A decline in short-term interest rates looms if forecasts of a weakening economy over the next six to 12 months hold true, some bond-market analysts say. And that would call for a change in strategy. "It's a good time for small investors to consider lengthening the maturity structure of their fixed-income portfolios," says Ken Volpert, a bond manager with Vanguard Group in Valley Forge, Pa. In other words: Consider longer-term investments.

The Federal Reserve has probably finished raising short-term interest rates, Mr. Volpert says, and while it is too early to forecast when the Fed will begin to lower them, mid-2007 is a good bet. In that case, it makes sense for investors to give up some immediate benefits in money-market funds and lock in the better durability of yield and income that bonds provide.

"The reinvestment risk on money-fund yields is currently huge," says Steve Bohlin, a bond-fund manager with Thornburg Investment Management in Santa Fe, N.M., so don't be complacent. He points to the year 2000, before the last recession, when money-market funds paid about 6 percent. By the end of 2001, as the economy fell, rates fell below 2 percent.

To avoid such a drop now, Mr. Bohlin says that investors should shift to a high-quality, intermediate-term bond fund with a mix of US government, mortgage, and corporate bonds. "It's a smart place to be right now," he says.

Intermediate-bond funds, widely seen as core bond holdings by investment professionals, typically own fixed-income securities with an average maturity of five to 10 years. These funds are less volatile than funds focused on longer maturities, yet they yield only slightly less (current returns range from 4.5 to 5.25 percent). "Intermediate-term bonds, more so than short- maturity ones, would reap capital gains if rates decline as the economy slows," says Jeff Tjornehoj, a senior analyst at Lipper.

As interest rates fall, bond prices rise. In the third quarter's vigorous bond rally, for example, intermediate bond funds returned 2.9 percent, according to Lipper. Long-term bond funds, which hold bonds with average maturities of about 12 years, returned a plumper 3.4 percent.

Most intermediate-bond funds own bonds given investment-grade ratings of BB or better by Standard & Poor's. Some of these funds make modest bets on lower-rated securities, including mortgage-backed or foreign bonds, in an effort to fatten returns. Often, such funds have "total return," "strategic," or "opportunity" in their names. "In the current environment," warns Mr. Jacobson, "you're not being paid to take on credit risk." Before buying any intermediate-bond fund, carefully review the credit ratings of portfolio holdings, and don't just look at broad averages, he says. Jacobson suggests avoiding funds with more than 10 percent of their holdings in bonds rated below BBB.

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