What's next? Ask the bond market

When it comes time to plot out your investment strategy, you probably focus most of your attention on how equities are doing and pay scant attention to the inner workings of bonds. But ignore the fixed-income market at your peril.

Trends in bond yields will often give you a better sense of the risks in the economy -- and by extension, your portfolio -- than stock prices can. Why? Equity investors are owners who care mostly about the upside potential of their holdings. Bond investors, by contrast, are creditors. They're worried about anything that could prevent them from getting paid back their money. So fixed-income investors are far more attuned to the current and near-term risks in the economy.

You don't need to be a credit expert to read the bond market's tea leaves. But it is helpful to brush up on basic concepts. The most important thing to remember is that bond prices and yields move in opposite directions. So when the demand for bonds grows and prices rise, yields will fall. That happened in last year's panic, when investors raced into safe 10-year Treasuries, driving down yields from nearly 4% to 2%.

With that in mind, here are two key trends to pay attention to.
The yield curve

Will the economy ever rebound? According to bond traders, it has already begun to do so. You can tell by looking at the yield curve, the spectrum of rates paid by short- and long-term bonds.

Since longer-dated bonds typically pay more than short-term debt, the yield curve usually slopes upward. But in August 2007, it was flat, with yields on 10-year Treasuries just two-tenths of a point higher than two-year notes. That's a sign of economic uncertainty, since it means scared investors are buying up bonds and weighing down long-term yields, just like last year.

What it's saying now. Today 10-year Treasuries are paying 2.6 points more than two-year notes, creating a steeper curve, a harbinger of growth. Still, don't assume the recovery will unfold quickly. The yield curve is sloping today not because 10-year yields have risen in a rapidly expanding economy, but because the Federal Reserve has been keeping short-term rates artificially low. "The Fed is sitting like a 10-ton elephant on the short end of the curve," says Carl Kaufman, manager of the Osterweis Strategic Income Fund.

What it means for you. In a slow recovery you want to invest in financially strong firms that offer the potential for stable, dependable growth and solid dividends. Vanguard Dividend Growth (VDIGX) offers a low-cost way to do just that.
The high-yield spread

Is the credit crisis over? Check the high-yield or junk bond spread - the gap between rates that corporations with shaky finances must pay their bondholders and yields on 10-year Treasuries. Last fall, junk bonds were paying out a record 22 points more than Treasuries, a sign that fixed-income traders were bracing for the Great Depression II.

What it's saying now. That spread has shrunk to less than 10 points, so fear has clearly subsided. But that's wider than the historic median of five points, so bond traders still think credit concerns exist.

What it means for you. With doomsday scenarios behind us, high-yield bonds have soared 30% this year. But it will take a big improvement in credit to justify further gains. So stick with funds that invest in safer, high-quality bonds. A good example: FPA New Income (FPNIX), which is in the Money 70, our list of recommended mutual funds.