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Bond Squad: Keep Expectations Reasonable for 2006

This year may be a year to prize bonds for their stability.

Scott Berry, 01/23/2006

<P><EM>Get mutual fund and stock information from our analyst team delivered to your e-mailbox every Tuesday. </EM><A href="http://advisor.morningstar.com/products/enews.asp" ><EM>Sign up for our free Investment Insights e-newsletter</EM></A><EM>.</EM></P> <P>We drone on and on about how difficult it is to accurately forecast the direction of interest rates or the direction of the bond market, so we aren't about to start predicting where rates will be a year from now. However, we can look at the current yield levels of the different bond market segments and make some judgments about their relative attractiveness or lack thereof.</P> <P><STRONG>What Do Current Yields Tell Us?</STRONG></P> <P>Take the high-yield bond market, for example. With yields in the range of 7% to 8%, junk bonds are certainly offering more yield than Treasury issues. However, if defaults tick up or junk bonds yields move higher (along with market rates or on their own), prices could dip and investors could be left with just 5% or so of total return for the year, in line with what some of our favorite high-yield managers are predicting. But with short-term bonds and funds yielding 4.5% and being far less vulnerable to market fluctuations, it's hard to make a strong case for riskier high-yield funds at the moment.</P> <P>Of course, the same could be said about intermediate- and long-term bonds. The Federal Reserve has pushed short-term interest rates dramatically higher over the past 20 months, but intermediate- and long-term bond yields haven't moved much at all, as foreign buying and future market expectations have kept yields down. The upshot is that short-term bond yields are nearly on top of, and in some cases superior to, intermediate- and long-term yields. In fact, the two-year Treasury recently yielded 4.38%, while the 10-year yielded 4.41%. We see the same with funds. Fidelity Short-Term Bond <?XML:NAMESPACE PREFIX = MSTR /?><MSTR:SECURITY>FSHBX</MSTR:SECURITY> recently offered a 4.4% yield, for example, while Fidelity Intermediate Bond <MSTR:SECURITY>FTHRX</MSTR:SECURITY> offered just 4.31%.</P> <P><STRONG>Is Opportunity Knocking Anywhere?</STRONG></P> <P>One area that is offering some potential opportunity is the municipal-bond market. On a tax equivalent basis, intermediate- and longer-term municipal bonds are offering considerably more yield than many taxable issues (short-term municipals are not offering the same advantage, however). Investors can scoop up AAA 10-year municipals yielding 3.91%, for example. That's a 5.43% taxable-equivalent yield for investors in the 28% tax bracket. Investors willing to take on the added interest-rate risk of 15-year and longer bonds can pocket the equivalent of 6% or more. The same holds true for many municipal-bond funds. Vanguard Intermediate-Term Tax-Exempt <MSTR:SECURITY>VWITX</MSTR:SECURITY> recently yielded 3.68% (5.11% taxable equivalent), for example, while Vanguard Intermediate-Term Bond Index <MSTR:SECURITY>VBIIX</MSTR:SECURITY> yielded 4.84%.</P> <P>World-bond funds and emerging-markets bond funds also offer some added yield. But the European Central Bank announced in November that it was poised to raise rates, which can hurt prices and dampen total returns, and the Bank of Japan could also raise rates. Add in currency fluctuations and the fact that emerging markets bonds (funds) have enjoyed an incredible seven-year run, and foreign bonds (funds) are no sure thing.</P> <P>Money market funds, on the other hand, are a sure thing, or a close as you can get in bond land. And many are now offering surprisingly competitive yields. In fact, Vanguard Prime Money Market yields 4.02%, while Fidelity Cash Reserves yields 3.97%. That's quite a jump from the 1% yields these funds and others were offering in 2004 and a welcome relief for those holding sizable positions in these cashlike vehicles.</P> <P><STRONG>Expect Stability, Not Firepower</STRONG></P> <P>If current yields are any indication, returns in bond land could be tightly compressed in 2006. Iran, Iraq, oil, inflation, jobs, the economy, interest rates, a new Fed chairman, and countless other factors could push the returns of different bond market sectors higher or lower, but we wouldn't be surprised to see most areas of the market deliver low- to mid-single-digit returns this year. That's not to suggest investors bail out of bond funds and hunker down in money market funds, but that they simply maintain reasonable expectations for this asset class, which should be prized more for its stability than for its firepower.</P> <P><EM>Scott Berry is an analyst with Morningstar.</EM></P>

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