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Investing in Bonds in the New Year

Options Exist to Hedge Against Rising Interest Rates

By Mike Anderson
Special to The Washington Post
Sunday, January 2, 2005; Page F06

It's almost heretical to suggest that a conservative investor hold anything less than 40 percent bonds.

Fixed-income investments, which pay a stable interest rate called a "coupon" over the life of a bond, have been viewed as a sanctuary from more volatile stock market returns for as long as anyone can remember.

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But at the start of 2005, some financial planners are sounding cautionary notes about fixed-income investments, which will fall in price if interest rates rise, as is expected this year.

It's not that planners are urging clients to tear up their asset-allocation plans and avoid bonds altogether. Instead, they are warning that the current environment is unusually challenging for fixed-income investors, with yield rates low relative to the risk of lower bond prices in the future.

"At the moment, I'm nervous about bonds," said Susan Lakatos, a New York-based certified financial planner and chartered financial analyst. "The issue right now is that there is a lot of risk about interest rates going up, which guarantees that prices will go down."

To be sure, not everyone is bearish on bonds. Michael Hoeh, head of securitized investment for CIC Bank of Paris, says the outlook going into 2005 is actually better than it was going into 2004. "Everybody at the beginning of 2004 was worried about rising rates."

But despite all the anxiety last year about the Federal Reserve's string of increases in short-term rates, the yield in the U.S benchmark rate, the 10-year Treasury note, actually slipped a tad. At the start of the 2004, the 10-year was priced to yield 4.26 percent, compared with 4.22 percent at year-end 2004. And while some analysts think higher interest rates have only been deferred, Hoeh is relatively sanguine about bonds. "We have better information about how the economy is growing and a decent comfort level that the Federal Reserve is doing the right thing."

He acknowledges that the yields on corporate bonds are looking a bit slim, meaning that people are taking on risk without getting the traditional compensation of higher yields. He cited the example of MGM Mirage (MGG), which in 2004 sold double-B+ rated bonds -- just below investment grade -- at a rate of 1.85 percentage points over the 10-year U.S. Treasury rate. By comparison, in 2000, MGM paid 2.82 percentage points over the 10-year.

Investors who are worried about higher rates can consider floating-rate bonds, whose yields would change along with the U.S. 10-year note or the London interbank offered rate (LIBOR), the world's best-known bond benchmark.

"Floating-rate issuance has been tremendous this year," Hoeh said. He cited figures showing that U.S. companies issued about $346 billion in floating-rate debt in 2004, up about 47 percent from the year before. Companies that issued floating-rate bonds last year included General Electric Co. (GE) and Wells Fargo & Co. (WFC).

Another possible hedge against rising interest rates lies in Treasury inflation-protected securities, known as TIPS. These U.S. government bonds, adjusted semiannually to cover any rise in inflation, offer some protection against higher rates as well, since inflation and higher rates often come together, Hoeh said.

Louis P. Stanasolovich, president of Legend Financial Advisors Inc. in Pittsburgh, is aggressively looking for floating-rate investments in 2005. There are many options here, but one of the easiest for average investors is the Pimco Floating Income Fund (PFIAX), he said. Eaton Vance Floating-Rate Income Trust (EFT) offers much the same thing in terms of protection against rising rates. And Pioneer Investment Management Inc. has announced plans to launch Pioneer Floating Rate Trust, a closed-end fund that will trade on the New York Stock Exchange under the symbol PHD.

Stanasolovich is also looking at bank-loan funds, which buy corporate loans from banks and package them as mutual-fund-type investments, as another possible hedge against rising interest rates.

"People will have to look at nontraditional investment and nontraditional strategies," Stanasolovich said.

Ben Shoval, a New York-based hedge fund manager, says a diversified bond fund is still a good bet for many investors. For example, the American Century International Bond (BEGBX) finished 2004 with a gain of nearly 9 percent. And while there is no guarantee that returns like that can last, Shoval would encourage investors to focus on their yields and not worry about the possibility of falling prices.

It's fine for younger investors with long time horizons to have as little as 20 percent bonds in their portfolio, Shoval said, but he is concerned that too many investors are chasing higher stock market returns that simply won't last in equities.

"I think the mentality has shifted back to the Internet boom mentality," he said. "People lost a lot of money, and I hope they don't do it again."

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