May 13 (Bloomberg) -- Declining bond-market volatility, a measure of risk, makes buying higher-yielding debt or longer- term Treasuries some of the most attractive trades in fixed income, according to JPMorgan Chase & Co. and Goldman Sachs Group Inc.

Merrill Lynch & Co.’s MOVE Index, based on prices of over- the-counter options on Treasuries maturing in two to 30 years, has dropped 52 percent to 126.3 since hitting a record high in October after the collapse of Lehman Brothers Holdings Inc. drove investors to the relative safety of government debt.

A record pace of corporate bond sales, declining money market rates and rising stock prices now all suggest the global economy is on the mend. Prospects of limited rate swings with the Federal Reserve forecast to keep its target lending rate near zero percent into next year make it more appealing for investors to exit the safety and relatively low returns of short-term government debt.

“One of the best ways to pick up carry in the fixed-income markets now is through credit-curve carry, which means you buy riskier assets like corporate bonds instead of Treasuries,” said Pavan Wadhwa, head of European interest-rate strategy in London at JPMorgan. “Lower volatility reduces both risk and liquidity premium. Anything that makes you carry in this environment is likely to stay in fashion.”

Moving Lower

Merrill indexes show Treasuries have lost 3.3 percent so far this year, the worst annual start since 1994, while higher- yielding bonds have gained and stocks rallied. The Standard & Poor’s 500 Index has climbed 31 percent since bottoming for the year on March 9. Investment-grade bond yields are now about 440 basis points more than 10-year Treasury note yields.

Fed policy makers lowered the benchmark interest rate to a target range of zero to 0.25 percent in December and switched to using credit programs and outright purchases of Treasuries as the main tool of monetary policy to pump cash into banks and bolster lending.

The precedent is there for volatility to fall further. In the 2001 recession, which lasted from March to November and included the Sept. 11 terrorist attacks, the Fed cut rates from 6.5 percent to 1.75 percent by December and then kept its target rate unchanged for nearly a year. With rates steady and the economy recovering, the MOVE Index fell from 166.5 at the end of 2001 to 91.9 by May 2002.

“Consistent with the idea that volatility will continue to subside, we recommend shifting exposure towards spread markets, including swap spreads related securities, and high quality investment grade names,” said Francesco Garzarelli, chief interest-rate strategist at Goldman Sachs International in London. “We have the same trading orientation now in both fixed income and foreign exchange markets - where our focus is on carry. In the lower volatility environment, with continued signs of the economy improving, investors want to trade-up risk.”

Carry Trade

The carry-trade strategy utilized in currency markets is when investors borrow in countries with lower interest costs and invest in those with higher rates. Goldman has been recommending the strategy since April.

In most swaps, two parties agree to exchange fixed for floating interest-rate payments over a period of time with the floating rate typically based on changes in the London interbank offered rate, or Libor. Swap rates serve as benchmarks for many types of debt often purchased with borrowed money, including mortgage-backed assets and auto-loan securities.

Adding to the prospects of subdued swings in government debt yields are the Fed’s purchases of government debt, according to Janaki Rao, an interest-rate strategist in New York at Morgan Stanley.

Fed Purchases

The Fed started buying up to $300 billion in Treasuries in March in a six-month program aimed to keep mortgage rates low. The Fed has bought $101.732 billion in U.S. debt through the operations, including $3.51 billion in bonds yesterday. The next purchase is scheduled for tomorrow.

“The size of Fed purchases of Treasuries could also expand similar to what was witnessed in the mortgage-backed securities space,” wrote Rao in a note to clients on May 1.

Policy makers in March increased purchases of mortgage- backed securities to $1.25 trillion year from $500 billion and doubled purchases of housing-agency debt to $200 billion.

To contact the reporter on this story: Liz Capo McCormick in New York at Emccormick7@bloomberg.net

Last Updated: May 13, 2009 15:34 EDT