Psst...Buy Bonds

By Daniel Kadlec

The most popular person at the party used to be the one flaunting the hottest stock tip. Pssst--zip drives. Ooh, baby! Not anymore. Today's darling is the geek in the corner explaining zero-coupon bonds. Zero what? You know, those tricky little devils that look like bonds and move like stocks and, um, are only up 25% this year after rising 22% last year. Ooh, baby! That's right. Just when you had given up on another year of 20%-plus investment gains (and having anything to gloat over), along comes a sharp decline in interest rates that has been a boon to interest-paying securities. Bond prices rise as yields fall. And boy, have yields been falling. Just three months ago, the government's benchmark 30-year Treasury bond carried a yield of 5.72%. Last week it was as low as 4.72% before drifting up to 5.12% on Friday. Amid tumbling rates, the average, boring government-bond mutual fund rose 4.6% in the third quarter--a period in which stock funds fell an average 15%. Since June 1996, T-bonds have risen 60%, vs. only 54% for the big stocks in the Standard & Poor's 500.

But the biggest spoils have gone to aggressive investors who own "zeros," which rise and fall about twice as fast as regular T-bonds. Zeros, up 9.3% in the third quarter, aren't as exotic as they sound. You may know them as TIGERS (Treasury income growth receipts) from Merrill Lynch or CATS (certificates of accrual on Treasury securities) from Salomon Smith Barney. Basically, a zero is a bond that pays no current interest and is sold at a deep discount to its face value. The interest payments are built into the price at which the holder redeems the bond when it matures in five to 30 years. Zeros are easily obtained through a broker, and there's a series of mutual funds called American Century Benham Group Target Maturities (800-345-2021) that invests in nothing but zeros. Those funds have been top performers this year.

But is it too late to buy bonds? Can interest rates keep sliding? We are at historic lows already, and rates are famously difficult to forecast. To make an additional 25% gain in zeros from here, the T-bond yield would have to drop to about 4%. A further tumble sounds incredible, I know. You have to recognize zeros as an aggressive bet. But it could pay. Inflation, the greatest threat to bondholders, is truly dead, and the world and U.S. economies are weakening fast--developments that argue for lower rates.

Beyond that, we have just begun to unwind a decade of indifference to risk. Since the early '90s, investors have been migrating to riskier assets like high-flying stocks and emerging-market securities in search of higher returns--leaving bonds and bank certificates of deposit behind. Now the inherent risk behind those high returns is becoming obvious, and the trend is reversing. This is the so-called flight to safety that you've heard about, and it's occurring at all levels--from fund investors who find they aren't so comfortable having everything they're worth tied up in stocks, to pros whose sophisticated strategies for dealing with risk have come unglued. The trend is very good for safe havens like T-bonds (zeros or plain old bonds) or even tax-free municipal bonds, which now offer enticing yields. It means that relative to junk and high-grade corporate bonds, emerging- market stocks and bonds, and even U.S. stocks, T-bonds will attract more money. Their yields must be driven so low that riskier assets finally look preferable again. And that could be low indeed, given the bloodletting under way on Wall Street.

See time.com/personal for more on zeros. E-mail Dan at kadlec@time.com And see him on CNNfn at 12:40 p.m. E.T. Tuesdays.