IN GENERAL, we believe investors should look to the stock market for capital appreciation, not the bond market. But there are times when the outlook for the bond market is particularly bright: If interest rates seem to be cresting and the economy slowing, then that would probably be a good time to make a speculative investment in bonds.
Of course, if you feel uncomfortable taking interest-rate risks with bonds, you should follow only a buy-and-hold strategy. But if you're willing to make a call on interest rates, you might as well focus on those choices that give you the biggest bang for the buck. Keep in mind, if you expect interest rates to rise, buying long-term bonds is not going to pay off. If bonds are paying 5% this year and 6% two years from now, in the future your 5% bonds will look paltry and you'll have a harder time selling them for a profit.
What makes all of this so tricky is that the sweet spot changes with your own goals as well as with the market. Bond performance, at times, can get particularly confusing because of an "inverted yield curve," which means the yields on long-term Treasurys were slightly below those with shorter durations. This happens when bond investors are worried about significant weakening in the U.S. economy.
Here's a look at how various types of bonds respond to changing interest rates:
Generally speaking, long-term zero-coupon bonds (i.e., bonds with a duration greater than 12 years) will give an investor the swiftest, biggest profit from falling interest rates. Issued by a range of sources including the government, these bonds are sold at deep discounts and pay no interest until they mature. This extra level of risk offers the possibility of greater reward. In addition, for investors in the higher tax brackets, since the upside gains in zeros are mostly capital gains, not interest income, they are taxed at a lower rate. That said, unless you buy a municipal zero, you'll still have to pay annual taxes on whatever income the bond does generate even though you won't receive that income until the bond matures.
The opportunity for profits during the right interest-rate environment is substantial. Consider this example. Say you paid $3,427 for a 20-year government zero with a 5.5% yield and a maturity value of $10,000. If over the course of the next year long-term interest rates were to fall by one percentage point, the bond's market value would increase by 20%.
Of course, interest rates can work against you, too. A one-percentage-point rise in rates over a year would hammer the bond's value by about 18%. Bottom line? Long-term zeros are for investors who are convinced interest rates are falling or for investors who intend to hold the bonds until they mature, thus making any price fluctuation meaningless.
Long-term Treasurys also stand to jump sharply in value if interest rates fall, and because they pay current interest, they're a bit less volatile than zeros. A 20-year long bond, for instance, has an upside potential of 13.5% in the event of a one-percentage-point interest-rate drop and a downside of -11.5%. Take a look for yourself at how much a change in price affects your yield by using our bond calculator.
Investors seeking less risk might want to consider 10-year zeros. These midrange zeros typically have a slightly lower yield than long-term bonds, but then again, they also have a more palatable downside. For example, if you held a 10-year zero with a 5% yield and interest rates dropped 1%, the bond would generate a 10% upside. On the other hand, if interest rates rose 1%, this bond would have a 9.1% downside.
Aggressive Corporate-Bond Funds
While we often prefer actual bonds to bond funds, when it comes to corporate funds we feel a bit differently. That's because navigating the landscape of aggressive corporate bonds can be tricky. The high-yield, or junk-bond market, can be treacherous-going because you're looking for a turnaround story. In other words, you're seeking a company whose prospects you believe will brighten, but which is highly risky at the moment.
Clearly this takes a lot of research but if you're right, the upside could be substantial. As the issuer's circumstances improve, so too will its credit quality. And that in turn means the price of the bonds (which you probably bought at a tidy discount) should rise. Beginning investors could benefit from the expertise of fund managers when it comes to choosing bonds, executing trades and managing call risk (i.e., reinvesting the proceeds if a company calls its bonds).