May 12, 2003 — Given the choice of throwing a bomb or dumping the ball off to a running back, bond market observers say the short game is best for the time being.

Fixed-income securities that mature in less than five years are attractive because they stand to be hurt the least if interest rates begin edging up later this year or in early 2004, investment professionals say.

Despite their recent rally and their inherent danger of defaulting, high-yield, or so-called junk bonds, are another alternative to consider, some say.

“Generally, right now, you don’t want to be too long, to my mind,” says David Wyss, chief economist at Standard & Poor’s. “If you look at the yields, I don’t see much point in going out past five years,” he adds.

Among Treasury and corporate bonds, Wyss says he favors those that come due within 2-3 years. He’s not enthusiastic about intermediate-term debt securities because if the Fed begins ratcheting up rates, they would carry “a fair amount of principal risk,” that is, the possibility of losing face value.

Similarly, long-term bonds and bond funds “will certainly take a hit” when rates move up, says Joel Friedman, an S&P director. For example, he points out, a 1% increase would cause a portfolio with an intermediate-term duration (a measure of sensitivity to interest rate changes) of five years to decline 5%; the loss for holdings with a ten-year duration would be 10%.

As for rates, William Reynolds, who heads the fixed-income division for T.Rowe Price Group (TROW), sees them heading higher, although the move “doesn’t appear to be imminent, given the state of the economy, which is sluggish, at best.”

Still, bond investors need to begin positioning themselves for the hike, starting this summer, and favoring short-term maturities is “a reasonable step,” says Reynolds, whose unit oversees about $50 billion in assets.

Wyss says the Federal Reserve could lower rates next month if data on the economy continues to be discouraging, but after that the central bank will begin tightening, he believes. However, the move up probably won’t start until next year because there doesn’t appear to be a threat of inflation on the horizon, and the economy’s performance has been lackluster, he says.

Turning to high-yield bonds, Wyss says he currently frowns on them because the difference in yields, or the spread, between junk and Treasuries has narrowed too much to justify owning them.

On the other hand, Friedman thinks the spread has a way to go before it becomes too small. According to a report by S&P Ratings Services, speculative-grade credit spreads were 730 basis points at the end of the first quarter this year, a decrease from their recent high of 1,011 basis points last October 10. The credit spread stood at 660 basis points on April 28, S&P said.

Price also feels the high-yield market will look good in the short run, if only because demand for junk bonds by fund investors has been strong in recent months. About $8.6 billion poured into these products between January and March, including some $3.9 billion in March alone, according to AMG Data Services, which tracks fund cash flows.

Funds that invest in junk bonds returned 5.4% on average in the first quarter, while the average domestic stock fund, excluding balanced and sector funds, lost 3.3%, S&P data showed.

“We view high yield as probably one of the better areas to be invested in for the next six months to a year, given our outlook for a general rise in interest rates and improvement in the economy,” Reynolds told Price investors at the end of last month.

Frank Cagnetti, a financial planner in Cincinnati, Ohio, suggests that investors hold a “small portion” of their assets in high-yield bonds. With the recession ended, the risk that these securities will default has lessened, and the spread between investment-grade and speculative-grade corporate bonds is “pretty wide,” he says.

Outside of junk bonds, Cagnetti and Wyss said they like Treasury inflation-protected securities, or TIPS. The bonds, and mutual funds that invest in them, offer the stability of Treasuries as well as the ability to beat inflation, should it arise.

In choosing bond funds, Wyss recommends that investors look for those with low expenses. “There’s no point in paying a lot for a bond fund,” he says. Companies offering low-cost bond funds include the Vanguard Group and Pacific Investment Management Co. (known as PIMCO), Wyss says. Fidelity Investments also features some low-cost bond funds, particularly in its Spartan family of products, he notes.

Cagnetti says he recommends Vanguard funds almost exclusively to his clients. “In bond funds, expenses mean, really, all the difference in the world,” he maintains.