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 likely be a good time to make a speculative investment in bonds. (Of course, if you feel uncomfortable taking risks with bonds, you should only follow the first part of our strategy.)
Which bonds should you buy? If you are going to make a call on interest rates, you might as well focus on those choices that give you the biggest bang for the buck:
Long-Term Zero-Coupon Treasury Bonds.
Zeros will give an investor the swiftest, biggest profit from falling interest rates. Issued by the government, these bonds are sold at deep discounts and pay no interest until they mature. For example, say you bought a 30-year zero with a 6.817% yield and a maturity value of $10,000 for about $1,359 (excluding commission). 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 improve by 38%, including both capital appreciation and accruing interest. On the downside, a one percentage point rise in rates over a year would hammer the bond's value by 20%. (To make matters worse, holders of zeros are obliged to pay taxes each year on the accrued but unpaid interest.) Long-term zeros are for investors who are convinced interest rates are falling, who can keep a daily watch over them and who don't mind selling in a heartbeat if the interest-rate outlook changes.
The instinct of many investors may be to choose long-term Treasury bonds as the next-best option. 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 30-year long bond, for instance, has an upside potential of 20.5% in the event of a one-percentage-point interest-rate drop after one year and a downside of only negative 5%.
If investors are going to move down to this risk level, they might as well move to 10-year zeros. Compared with long bonds, these midrange zeros have only a slightly lower upside potential and a more palatable downside: up 16% if rates drop one percentage point, down 2% if rates rise that much. 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.
Another way to make zero plays is through the Benham Target Maturities funds offered by American Century (800-345-2021). Benham has six no-load portfolios, each with a minimum initial investment of $2,500, that aim to match as closely as possible the return of individual zeros maturing in the years 2000, 2005, 2010, 2015, 2020 and 2025. You can even construct your own ladder of speculative zeros at minimal cost.
Aggressive Corporate-Bond Funds.
While we often prefer actual bonds to bond funds, corporate funds are different -- they offer investors the expertise of fund managers in choosing bonds, executing trades and managing call risk (i.e., reinvesting the proceeds if a company calls its bonds). Unlike zeros, they have a substantial income element that cushions their risk.