News & Our Thinking

Bond investors are a perverse crowd. Happiness for the rest of us can make bond holders grouchy and poorer. Right now, the bond crowd is in a world of worry.

“The greatest risk is that the economy is improving,” says Mario DeRose, fixed income strategist at the Edward Jones brokerage in Des Peres.

An improving economy probably means higher interest rates ahead, and that means lower bond prices.

Consumers are opening their wallets a little more; companies are hiring more; the unemployment rate is inching downward, although it’s still high at 8.8 percent. The consensus among economists is that the U.S. economy should grow at a healthy 3.1 percent this year.

So, analysts say this isn’t the moment to plow the family fortune into U.S. corporate bonds, and certainly not into Treasuries. They generally think stocks offer better prospects this year.

But if you have a yearning for fixed income, look at municipal bonds, which have already taken their beating. Investors with a strong stomach might consider a risk on junk bonds.

Corporate bonds came back big over the past two years as investors realized that American business would not go belly up in the financial crisis.

But now they face a double whammy. Besides the risk of higher rates, certain corporate leaders have a special beating planned for their companies’ bond holders.

American corporations are sitting on piles of cash, which makes their bond holders feel nice and secure. But with the economy looking up, analysts suspect that companies are about to spend that cash in a spree of acquisitions, while taking on more debt.

Exhibit A is AT&T’s $39 billion bid for rival T-Mobile. “There’s hardly any bond manager in the world that doesn’t own AT&T,” moans Scott Colbert, head of fixed income investing at Commerce Trust Co.

More debt and less cash can lower a company’s bond rating, and that means a lower market price for the company’s existing bonds.

Meanwhile, holders of all sorts of bonds have to worry about interest rates. Chances are that higher rates are coming, but nobody’s sure just when. For the moment, the Federal Reserve seems more concerned with high unemployment than with the risk of inflation. But with the economy slowly improving, Fed officials are sending up early smoke signals indicating that they won’t be quite as easy on investors in the last half of 2011.

The Fed’s $600 billion bond-buying program, designed to hold down intermediate interest rates, ends in June and Fed officials seem in no mood to extend it.

On the other hand, Fed watchers expect the central bank to keep short-term rates near zero until at least late this year, and probably into next year.

“There’s bound to be some pressure on interest rates, especially in the short to intermediate area,” says Colbert.

He thinks the long end of the bond market has already adjusted to the chance of higher rates. The 30-year Treasury bond yielded 4.5 percent on Friday, up from 3.6 percent last summer.

“The individual’s best bet is in the municipal space,” says Colbert.

MUNI OPPORTUNITY

Munis took a drubbing beginning in December, as investors read about possible impending defaults in places like Harrisburg, Pa.

Then along came the respected securities analyst Meredith Whitney predicting “hundreds of billions of dollars” in municipal defaults.

That set off a panic in the muni market, which is dominated by small investors. The market hit bottom in January.

Colbert and DeRose say the panic was overdone. Sure, there will be defaults, but not enough to justify today’s lower prices.

An investment grade intermediate-term bond fund will yield about 3.2 percent in interest. Muni interest is exempt from federal income taxes. So, that yield is the equivalent of 4.3 for someone in the middle-class 25 percent tax bracket.

The safest munis are “general obligation” bonds, which require governments to make the payments even if they have to raise taxes. Next safest are “essential services” bonds issued by municipal utilities, sewer districts and the like. They can raise rates and customers have to pay. Last on the list are revenue bonds backed only by the income of a certain project, such as a shopping center.

Small investors tend to think of bonds as safe. They’re safer than stocks by far, but they can still show losses.

“I don’t think people have any clue how much they can lose in bonds,” says Steve Finnerty, chairman of Argent Capital Management in Clayton.

Of course, that depends on how you invest. If you buy individual bonds, and hold them to maturity, you’ll get the face value of the bond — providing the issuer doesn’t go broke first.

But individual bonds can be a bit clunky to own. Small-fry investors don’t get the best price when they buy and sell. And, unless you’re investing lots of money, it’s hard to assemble enough of them to get the safety that comes with diversification.

That’s why many investors choose bond mutual funds. But bond funds never mature, so their value changes with the market price of the bonds they hold. Rising interest rates mean lower bond prices and vice versa.

You can get a handle on your vulnerability by checking the fund’s “duration.” The duration number is the amount the fund’s value will rise or fall with a 1 percentage point change in interest rates.

For instance, a typical intermediate-term bond fund might have a duration of five. If interest rates rise 1 percent, the fund will lose about 5 percent of its value and vice versa. The bond’s interest yield will make up part of any loss.