Playing It Slow

By Daniel Kadlec

With tech stocks limping, the dow underwater for the year and most everyone's tea leaves pointing to a slower economy, you may find yourself thinking the unthinkable: Time to buy bonds. Ugh. You wouldn't be nuts. Fixed income is a great place to hide in a slowdown, especially one that spills into recession. The last time that happened was 1990, which is also the last time that both bonds and cash outperformed stocks for a calendar year.

The numbers hint that such a scenario is taking shape again. Treasury bonds this year have returned 13.9% and cash (T bills) 3.9%, both outstripping the 2.2% return from stocks, according to Ibbotson Associates. The disparity is less dramatic after taxes. Bonds are taxed as ordinary income; stocks are taxed as capital gains, normally a lower rate. Still, these returns are unusual and suggest there is something in the air. Investors have responded by taking their most defensive posture in years. It all seems a little overdone. Few economists forecast a recession anytime soon. Yet with the often unsettling month of October looming and growth clearly slowing, being defensive makes some sense. As the economy slows, assuming interest rates decline with the slowdown, long-term bond yields will decline. That makes existing bonds more valuable because of the higher interest rate they pay. Michael O'Higgins, manager of the O'Higgins Fund, believes T-bond yields can drop to about 4.6% in 12 months, from about 5.8% now. That would translate into a 15% total return for most bond funds.

The easiest way to own bonds is through a fund, though individual bonds are a better deal for folks with more than $100,000 to invest. Individual bonds mature, and you get your money back in addition to the regular interest payments you received during their life. Like some old friends, bond funds never mature. When you sell, you get the market value of bonds in the fund. The best bond funds to buy have an above-average five-year record and below-average expenses.

To make an aggressive bet on falling interest rates, consider a fund that buys zero-coupon bonds, which are hypersensitive to rate moves. Zeros are bought for a fraction of face value and make no regular interest payments but are redeemed at face value when they mature (unlike those old friends, they always do). The O'Higgins Fund and American Century Target 2025 are solid choices, both having returned more than 23% this year. Warning: returns would fall fast if rates head sharply higher, something few economists expect.

For bonds to pay big from here, we would probably have to have a recession. If one doesn't emerge, stocks will take the lead again. But be ready to say goodbye to those 20%-plus years. One argument for stocks now: since World War II, eight times at this point in the year bonds were up while stocks were down, reports Salomon Smith Barney. Each time stocks rallied through year-end as whatever fears had gripped investors abated. The average four-month gain in those instances was 11%. But even if this year makes it a perfect nine for nine, bonds could do well too. So listen to your gut. Bonds are a great choice if you're worried--and you won't feel sick if stocks lift off without you.

See time.com/personal for more on asset allocation. E-mail Dan at kadlec@time.com See him Tues. on CNNfn at 12:20 p.m. E.T.