For investors, how bonds behave is far from intuitive. Their prices move in the opposite direction of their yields, and then you've got to contend with inflation, call options, and credit quality, not to mention a handful of nuances that apply to each breed of bonds—high yield (junk), municipal, corporate, and government. But here's the main concept: In theory, bonds provide a safe haven amid market turmoil.
Despite that conservative reputation, bonds aren't always safe. And these days, they're not a sure thing. "This crisis is a different story," says Marilyn Cohen, president and chief executive of Envision Capital Management, a Los Angeles firm that manages $185 million in bond portfolios for individual investors. "It's a crisis of confidence. It's a crisis in credit. With banks being seized, brokerage firms being bought out, and fear in the markets, investors are flocking from just about every type of bond because of the perceived risk of owning anything but U.S. treasuries." That reluctance isn't unfounded. "If a corporate bond looks good today, the next day it might be trash if there's a negative event," says Cohen, who is also coauthor of The Bond Bible.
Investors can gauge the risk of a particular bond—or a class of bonds—by comparing them with treasury yields. "If someone is going to buy a corporate bond that matures in five years that yields 6 percent, they can base-line it against five-year treasuries, which currently yield 2.77 percent," says Cohen. "The wider the spread, the more generous the yield on the corporate bond. Here's the question you need to ask: Is the difference between 6 percent and 2.77 percent (3.23 percentage points) worth the risk?"
Less mystery. Bond-fund investors should be scrutinizing their holdings. Funds filled with government IOUs are airtight, but the pay is paltry. (And Cohen believes interest rates will stay down this year and next.) Consider that Vanguard's Intermediate-Term Investment-Grade fund, made up of high-grade corporate bonds, yields 6.9 percent, while its Intermediate Treasury fund pays 3 percent. By comparison, the municipal-bond version of that fund pays 4.3 percent, which equates to a tax-equivalent yield of 7 percent for an investor in the 28 percent federal tax bracket.
For those in the upper tax brackets, Cohen says municipal bonds are the best bet. "When the economy is bad, you have states, cities, and counties scrambling for revenues, so there's a huge backlog of issues yet to be unleashed," she says. Muni investors also get the benefit of tax-free income, less volatility than corporate bonds, and "theoretically more safety, assuming you're in large, quality, general-obligation bonds."
Cohen began investing in junior high with baby-sitting money (in stocks—bonds came later). She prefers individual bonds to funds, because there's less mystery. "Funds hold an array of issues, plus inflows and outflows can work against you in a credit crisis," she says. The drawback: A diversified portfolio of single bonds requires roughly $200,000. Regardless of what type of bond investment you have, Cohen says, "credit quality is the name of the game right now."