Yield Curve Anomaly Doesn't Repeal a Basic Rule: Diversification

By Meg Richards
Associated Press
Sunday, January 22, 2006

Although parts of the Treasury bond yield curve have inverted, experts say there's no reason to despair, as the phenomenon likely reflects the rising demand of foreign banks for longer-term securities and not imminent economic doom. As baffling as this has been for the bond market, the basic rules still apply for fund investors: Smart diversification is the key.

The flattening or inversion of the yield curve, which occurs when longer-dated Treasury notes pay lower yields than those with shorter maturities, has been lamented by analysts and investors because it has been associated with recessions in the past. But this time is different, many Wall Street professionals say, because the pressure on the 10-year note stems from the robust demand of Asian central banks and other buyers, rather than a slowing economy and rising inflation.

"There are buyers who have to buy the long end of the maturity securities; they're immunizing portfolios and pensions with long-term obligations, and they have to buy no matter what," said Michael W. Boone, a money manager in Bellevue, Wash. "They're not buying the 4.5 percent 10-year Treasury thinking it will make them a lot of money; they're buying because they have obligations they have to match."

For regular folks, it's been a frustrating climate for investing in bonds, Boone said. People have been told repeatedly to stick with shorter-term maturities, but it's been a tough area to make money in lately because yields have gone up so rapidly. But short- to intermediate-term bond funds, essentially anything with a maturity of five years or less, remain good investments.

"Markets always make it tough to do the right thing, and people have not done well, unless they've been in a money market, in the shorter-term securities," Boone said. "They're afraid of long-term rates, which makes sense, but short-term rates went up so much faster; even short-term bonds performed poorly. The temptation may be to bail out on short-term bonds, but I think that would be a bad idea."

If you're uncertain about what to do with the bond portion of your portfolio, take a step back and eyeball your overall strategy, said Jeff Tjornehoj, a research analyst with fund tracker Lipper Inc. A good fund to use as the centerpiece of your fixed-income allocation might be one that invests in intermediate investment-grade debt. The largest fund category in terms of dollars outside the money market, they generally benchmark the Lehman Aggregate Bond Index, which means they hold everything from government securities and corporate debt to high-yield.

The overall bond market rose 2.43 percent in 2005. To put things in perspective, Tjornehoj said, the Lehman Aggregate index saw its worst year in 1994, when it dipped 2.9 percent. Its best year came in 1985, when bonds were up 22 percent amid an inflationary climate. More recently, the index gained 10 percent in 2002, 4.1 percent in 2003 and 4.3 percent in 2004.

You can invest in this universe of bonds through an exchange-traded fund, the iShares Lehman Aggregate Bond (AGG), but you may do better with a more established traditional mutual fund. Reasonably priced options include Vanguard Total Bond Market Index (VBMFX), Fidelity U.S. Bond Index (FBIDX) and Harbor Bond (HABDX).

If you want to add to your core bond holding, you might consider allocating a smaller portion overseas. Emerging-market debt, in particular, has posted strong returns -- rising an average 15.9 percent annually over the past five years, and 13.7 percent over the past decade -- though that performance can be accompanied by equity-like volatility. Fidelity New Markets Income (FNMIX) and Pimco Emerging Markets Bond (PAEMX) are two funds with strong records and reasonable expenses.

"Relative to other fixed income, it would seem more risky," Tjornehoj said. "Certainly, a change in political leadership in Brazil or Mexico can have a huge impact on returns. The sovereign debt often gets painted with the same brush. But for the most part, this debt has done a great job over the past several years because those countries have been getting their act together."

Another area to watch is municipal bonds. Though they've long been considered the province of rich or elderly investors, these tax-free securities can be a great value for anyone. They have high credit quality and yields comparable to Treasurys. And if you are careful to purchase tax-free funds focused on muni bonds issued by your own state, you get to keep your whole return, which makes a muni with a 4 to 5 percent return the taxable equivalent to a much riskier, higher-yielding investment.

While an argument can be made that investors might be better off putting their shorter-term money in certificates of deposit, which are currently paying up to 5 percent, the lack of foreign appetite for munis make them a good bet on the longer end, Boone said. Plus, owning munis adds to your portfolio's diversification. Just remember that because they're tax-free, there's no point in holding them in a tax-deferred account.

© 2006 The Washington Post Company