Post-Recession Bond Strategy Deserves Fresh Look

OCEAN CITY - With the economy continuing to show signs of growth, a dreaded "double-dip" recession is looking increasingly unlikely, says Martin Mauro, Fixed Income Strategist at BofA Merrill Lynch Global Research. As a result, even the most conservative investors may need to consider that the bond strategies that saw them through the recession •€' particularly the flight to the safety of U.S. Treasury bonds •€' could be due for a review.

Not that U.S. Treasury bonds don't still have a place in investors' portfolios. It's just that yields on shorter maturities have fallen to the point that they're now at risk of lagging behind inflation, especially after taxes, Mauro says. By contrast, after sliding during 2008, yields on intermediate- and long-term Treasuries are inching up again.

"We believe the yield on the 10-year Treasury could reach 4.25% by the end of 2010 and 4.5% by the end of 2011," Mauro predicts.

That's not necessarily good news for existing bondholders, because rising bond yields translate to lower bond prices. In fact, total returns •€' the combination of yield plus price appreciation •€' for Treasuries have recently trailed those of other fixed income investments.

You can consult with your financial advisor to decide on the best mix of fixed income holdings for your investment objectives, but Mauro does have some suggestions. Conservative investors can start by considering investment-grade corporate bonds, particularly in the insurance, energy, and food and beverage industries. More aggressive investors may opt for slightly higher risks in return for the enhanced yields of some corporate bonds with B or even BB ratings, as well as certain mortgage-backed securities (like those backed by the Government National Mortgage Association, or Ginnie Mae) at the safer end of the credit scale.

Mauro recommends emphasizing the intermediate range •€' between five and 15 years •€' although conservative investors might opt for shorter maturities. Long-term bonds will provide slightly higher yields, but the difference won't be worth the additional risk of tying up your money for an extended period during a time when inflation remains a threat.

For the tax-conscious, Mauro suggests high-quality municipal bonds. As one of the few investment vehicles shielded from federal (and in some cases, state) taxes, munis have become a particularly attractive option because top income tax rates for the highest bracket are likely to rise next year. Though many state and city issuers continue to face serious budget pressures, the default rate on investment-grade munis is actually exceedingly low. Investors can further minimize their risk by sticking with only the highest-grade general obligation bonds or by opting for bonds that support essential services, such as sewer and water systems, which city and state leaders are normally at pains to protect from default.

Now that equities appear to be (at least fitfully) on the mend, bonds are likely to resume their traditional role of providing a source of income and steady returns that can buffer stock market volatility. But that's only if your bond strategy keeps up with the times. With economic conditions improving, a less conservative but still well-diversified allocation to bonds could help boost your current income without jeopardizing your long-term financial goals.

(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)