- The Washington Times - Monday, January 23, 2006

Although parts of the Treasury bond yield curve have inverted, specialists 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 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, Mr. Boone said. People have been told repeatedly to stick with shorter-term maturities, but it’s been a tough area in which to make money 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,” Mr. 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 are uncertain about what to do with the bond portion of your portfolio, take a step back and eyeball your overall strategy, said Jeff Tjornejoj, a research analyst with fund-tracker Lipper. 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 and corporate debt to high yield.

The overall bond market rose about 2.43 percent in 2005. To put things in perspective, Mr. Tjornejoj said, the Lehman Aggregate Index’s worst year was 1994, when it dipped 2.9 percent. Its best year was 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, but you might do better with a more established traditional mutual fund; reasonably priced options include Vanguard Total Bond Market Index, Fidelity U.S. Bond Index and Harbor Bond.

If you want to add to your core bond holding, consider allocating a smaller portion overseas. Emerging market debt, in particular, has posted strong returns — rising 15.9 percent annually over the past five years, and 13.7 percent over the past decade — though that performance can be accompanied by equitylike volatility. Fidelity New Markets Income and PIMCO Emerging Markets Bond are two with strong records and reasonable expenses.

“Relative to other fixed income, it would seem more risky,” Mr. Tjornejoj 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 last several years because those countries have been getting their act together.”

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

While CDs be a good bet for short-sterm savings, munis are best for longer-term fixed-income savings needs.

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