Creating a Winning Bond Strategy

With the right approach, bonds can achieve outstanding returns in a volatile market.Here's how.

are the least volatile. Prices for shorter dated investments don’t move around as much as those maturing later on.

Of course, short bonds yield less than those with longer time horizons, since investors don’t expect the same kind of reward for lending money for five years as they would for 10. Therefore, a 10-year Treasury note yields 4.17% today, but the five-year sports just a 3.5% yield. “I would be focusing on figuring out the point where you get the most yields for the least amount of interest rate risk,” says Pugh. “For an individual, it’s the intermediate maturities.”

You could put new money to work in the shortest dated bonds to even out longer bond holdings. Or you could sell everything and simply buy within the five-year range. Alternately, you can invest in a fund that plays the intermediate segment of the bond market such as the Vanguard Intermediate-Term Bond Index Fund (800-662-7447). The fund has a 6.8% three-year annualized rate of return.

Junk Bonds Another way to stem the damage from rising rates is to look at junk, or high-yield, bonds–those given a grade of BB or lower by one of the credit rating agencies such as Standard & Poor’s or Moody’s Investors Service. The juicy yields make them less sensitive to interest rates, since investors determine prices by judging a company’s ability to pay back its debt, not the direction of interest rates.

Over the last two years, as the economy has revived and corporate finances have improved, investors have become downright smitten with junk. Whereas in mid-2002, high-yield debt paid over 10 percentage points more than Treasury bonds with similar maturities, today that yield differential is just 3.5 percentage points. Last year, junk bonds returned 10.9% on top of a 28.2% gain the year before–results that bested equities.

“There’s some bang for the buck in high-yield bonds,” says Ek. “You might say that the risk/return is not as fat as it has been, but you are still being rewarded incrementally for taking on that credit risk.”

Extra yield, plus less interest rate sensitivity. Sounds good, right? Not so fast. Putting just 5% to 10% of your bond portfolio into junk bonds is plenty. “When things go bad in high-yield, it happens very quickly,” says Ned Notzon, a bond manager with T. Rowe Price Investments in Baltimore. “It can happen in just a few months’ time. You’re very unlikely to see investment-grade corporate [bonds] behave that way.”

Try a fund like T. Rowe Price High-Yield (800-638-5660). It has an 11.3% three-year annualized rate of return.

Mutual Funds For the vast majority of investors, a low-priced bond fund will suit them fine. Just ask Donna Ginn, owner of a Miami-based organization and management development firm, Ginn Scroggins & Associates. Ginn, who is in her mid-50s, is worried that interest rates will wreak havoc on the 40% of her portfolio she has allotted to bonds. So she’s shortened the overall maturity of her portfolio, bought international fixed-income securities, and added some floating-rate bonds that respond quickly

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