Last year, the best choice in the bond market was 30-year Treasuries. The federal budget surplus enabled the Treasury Department to redeem long-term bonds instead of issuing new ones.
Reduced supply and increased demand drove up the prices of long-term Treasuries. Such bonds had a total return over 20% in 2000, one of the best years on record.
The picture is different now. The Federal Reserve probably will lower short-term interest rates in order to strengthen the economy. That may create fears of inflation, which would raise long-term interest rates and hurt the prices of long-term bonds.
So what looks attractive now? Some bond market pros favor mortgage-backed securities issued by federal agencies such as Ginnie Mae and Fannie Mae. Mortgage-backed securities are high-quality holdings, currently yielding around 7%, while Treasury bonds with comparable maturities pay less than 6%.
Moreover, mortgage-backed securities are defensive plays. That is, investors receive a return of principal each month, as homeowners pay down mortgages. That money can be reinvested at higher yields, if interest rates rise.
Top-rated mutual funds holding mortgage-backed securities include Vanguard GNMA (800-662-7447) and Strong Government Securities (800-368-1030).
