A Few Things That You Can ‘Safely’ Assume About Bonds

In typically hyped fashion, the headline on the cover of the September issue of Money magazine made this claim: “Invest Safely and Make 20% or More.” Yeah, I bought a copy. Even more outlandish, the story turned out to be about bonds.

Now, there is no way you can make 20% “safely” with bonds. Even unsafely, the only way to do it is: 1) Buy the bonds of some woebegone country like Afghanistan or Haiti and hope you get paid back, or 2) Buy a U.S. Treasury bond paying 7% interest and hope that rates will drop sharply.

Money magazine, drawing on the prognostications of its chief investment strategist, Michael Sivy, suggests the latter course.

If you buy a bond that pays 7% and, a year later, new bonds are paying only 6%, then your old bond--quite naturally--will be worth a lot more.

So will rates fall a full point? No one has the slightest idea. The track record of experts in forecasting even the direction of interest rates is famously miserable.

But the right way to invest in bonds is to forget about predicting rates--and forget about making 20%. Bonds are not for speculation. They are for one of these three uses:

* To generate reliable income for paying living expenses.

* To provide a modest, truly safe return for a relatively short period. For instance, if you have a child beginning college in two years, then your investment dollars should go solely into bonds, not into stocks--which are too volatile over such a brief period.

* To serve as ballast in a diversified portfolio. Bonds have provided more consistent, albeit lower, returns than stocks.

But to use bonds in these ways, you have to be prudent. You can lose lots of money playing the game Money magazine suggests--buying bonds that mature way out in the future and selling them if interest rates fall. The problem, of course, is that rates could rise and you could lose 20%.

I’ve believed for a long time that since the purpose of bonds is to provide safety and reliability, the smartest strategy is simply to buy U.S. Treasury securities and hold them until maturity. Or, if you need income that’s exempt from federal taxes, do the same with municipal bonds.

When you keep a Treasury bond until maturity, you are sure of getting its full face value: $1,000 for a $1,000 bond. But if you sell it before maturity, you could get less (if rates in general rise) or more (if they fall).

Buying an individual U.S. bond is relatively easy; you can do it through a bank or broker or directly through the Treasury ([202] 874-4000).

Buying an individual muni is more complicated. Brokerage expenses are often high, you’re not certain to get the best price and, since there’s some risk involved, you really need diversification--that is, at least five or six different muni issues.

Although bond mutual funds would seem to be the solution to some of these problems, I have recommended against them in the past for this reason: Bond funds own ever-changing portfolios of bonds. Because funds never “mature,” you can’t be certain of getting your entire original investment back.

Lately, I’ve changed my mind. I ran across a family of bond funds--run by Thornburg Securities Corp.--that operate on a principle called “laddering.” The result is that the net asset value (or price) of the funds remains remarkably stable.

In other words, if you put your money into Thornburg funds, you have an excellent chance of getting all of it back, no matter when you sell--and along the way, you’ll collect some nice income.

The funds were launched by H. Garrett Thornburg Jr., who left Bear, Stearns & Co., the big New York investment firm, in 1982 to start his own company in Santa Fe, N.M., far from Wall Street’s madding crowd. Thornburg can be reached at (800) 847-0200.

Laddering is buying bonds that mature in successive years, so you keep replacing them.

You can do this yourself too. Say you have $50,000 to invest in bonds. Instead of putting all your money into bonds that come due in five years, you put $10,000 into bonds that mature in one year, $10,000 in bonds that mature in two years and so on.

When the first-year bonds mature, you put the proceeds into a new bond that matures in five years. Then you continue the process. Your portfolio always contains five bonds, maturing one year after another.

“Consider an environment of increasing interest rates,” says a Thornburg investor guide. That’s a bond investor’s worst nightmare. But with laddering, “as the shortest bonds in the portfolio mature, we have the opportunity to reinvest the proceeds at the new higher yields in longer maturities.”

The result is low volatility and stable income.

Of course, if you were absolutely certain that interest rates would decline, you could buy a 30-year Treasury bond and lock in 6.8% now. But what a bet to make! “You have to look at seven more presidential terms before the long bond matures,” Thornburg said. “You have a Social Security crisis looming. The truth is that buying long-term bonds is riskier than buying Netscape stock.”

He’s right, and he offers an attractive alternative. The manager of the U.S. government fund, Stephen Bohlin, “keeps the portfolio evenly laddered across the maturity schedule,” writes Hal Raner, an analyst with Morningstar Inc. “Most managers seek to add value by betting that certain parts of the curve will provide above-average returns during a given period of time.”

However, I’m not sure I would be willing to pay the hefty load (2.5%) and the full percentage point in annual expenses to own Thornburg’s U.S. government fund. I can do the laddering myself. But on his muni funds, I wouldn’t hesitate.

The big risk with munis is the specter of lower tax rates or even a flat tax that would exempt the interest of all bonds (not just those issued by state and local agencies) from federal tax. But judging from the way this year’s election campaign is going, I’d say that such changes are hardly imminent.