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How Did Bonds Get So Sexy?

BusinessWeek Investor: Bonds

How Did Bonds Get So Sexy?

They're beating equities, but picking the right kind isn't easy

When Jerry Thunelius, head of taxable fixed-income investments at Dreyfus Corp. speaks before brokers and their clients, he asks them this question: "Who owns stocks?" Everyone responds by raising a hand, he says. Thunelius then asks the crowd who owns bonds. "On average, two to three percent raise their hands," he says. If that's so, then many investors may be missing an investment whose returns could come closer to stocks over the next few years, but with less risk. With the economy slowing, bonds may be set to become market leaders.

Indeed, for the first time since 1993, bonds are outperforming the stock market. From January through Oct. 20, the Lehman Brothers Aggregate Bond Index is up 8.06% and U.S. Treasury bonds maturing in 20 years or more have fared even better, gaining 15.53%. By comparison, the Nasdaq Composite Index is off 14.40% for the year and the Standard & Poor's 500-stock index is down 4.92%.

The $15 trillion U.S. bond market, however, is not one harmonious entity. It's comprised of a variety of markets that often dance to different beats. U.S. Treasury bonds, for instance, have flourished this year because Uncle Sam is using some of the budget surplus to retire debt. Supply in the municipal bond market has similarly tightened--driving down the average yield for top-quality, 10-year munis from 5.09% in January to 4.78% recently--because the strong economy has lessened states' and cities' need to borrow. By contrast, the junk bond market is being bashed by concerns about deteriorating credit quality. Junk bond yields have spurted from an average of less than five percentage points over comparable Treasuries at the start of the year to nearly eight now. That's the highest level since February, 1991.

To make decisions tougher, today's bond market is less liquid and thus far more volatile than a half-decade ago. That's because Wall Street firms, burned by losses in 1998 after Russia defaulted on debt, are increasingly reluctant to put their capital at risk to make markets in bonds.

Shifting some money into bonds doesn't mean giving up on stocks. History shows that a combination of both stocks and bonds reduces portfolio risk more than it reduces returns. Ibbotson Associates figures that a portfolio comprised of 40% bonds and 60% S&P stocks would have earned an average of 13.3% annually since January, 1990, vs. 16.7% yearly for the S&P alone. But the bond-stock portfolio would have been 40% less volatile (chart, page 210).

QUALITY BECKONS. Slowing economic growth, which crimps corporate profits, is hurting stocks. It's also roiling some sectors of the bond market, such as high-yield bonds, that are highly sensitive to companies' fortunes. But while the economy is slowing, there appears to be little chance of recession. Moderate growth coupled with a tame rate of inflation is a good backdrop for investing in high-quality bonds.

The aim of most bond investors is to earn the rate of interest a bond pays when they purchase it. If inflation rises, bond prices decline, and investors wind up with a lower return. But with most economists expecting the Federal Reserve to hold rates steady over the coming months, high-quality bond prices and yields should hold fairly even. Some economists believe the Fed's next big move will be to lower short-term rates early next year. If that happens, bond prices will increase, and investors will earn price appreciation on top of the bond's yield.

"High-quality bonds are a great buy right now," says Donald Berdine, chief investment officer at PNC Advisors in Pittsburgh, which manages $50 billion for wealthy individuals. Berdine, who suggests that clients keep 35% of their portfolios in bonds, especially favors municipal bonds for those in high tax brackets. One reason that Berdine is bullish on bonds is his belief that oil prices will trend lower over the next few months, allowing inflation to decline.

Berdine attributes the spike in September's consumer price index--to a 3.8% annualized rate from a 3.3% rate the prior month--largely to crude oil prices jumping 33% this year. He expects that by the middle of next year, the CPI will fall to a 2% rate, which he sees as the long-term inflation rate. By that measure, Berdine reckons bonds are cheap. Historically, bonds have returned around three percentage points more than inflation. With 10-year U.S. Treasury notes yielding about 5.6%, he figures investors are getting closer to four percentage points over the inflation rate.

Bond pros are divided about the best strategy. The riskier but potentially more rewarding approach is to be a value hunter, seeking out opportunities among beaten-down junk bonds and in the high-quality corporate market, which has also suffered from credit-quality jitters.

Indeed, value bond investor Laird Landmann of the top-performing Metropolitan West Total Return Bond Fund says he's scooping up top-notch corporate bonds like those issued by Ford Motor and Goldman Sachs, because they're selling at their highest yields in years relative to Treasuries. For instance, Landmann says he recently bought 10-year Goldman Sachs bonds yielding 7.8%, about two percentage points over the 10-year Treasury rate. In bond parlance, the Goldman bond is cheap.

True, Wall Street analysts recently lowered their earnings estimates for Goldman over concerns that underwriting fees will fall. Landmann points out that Goldman is a strong, diversified firm that can easily make good on its debt. In like manner, he is buying Bank of America bonds. Landmann admits, however, that the corporate bond market is still "full of minefields." He won't touch the bonds of most technology and telecom companies, since he believes their prospects can turn down quickly in an era of rapid technological change.

The other view is a far more cautious one. William Gross, managing director of Pacific Investment Management, which oversees $212 billion in bonds, advises investors to avoid the corporate bonds altogether, both investment grade as well as junk, because he believes more credit downgrades are on the way.

Since the start of the year, Gross has pared PIMCO Total Return Fund's corporate bond holdings to 12% from 20%. Just 1% of the fund's assets sit in junk bonds, down from 4% last year. "In this kind of environment, investors tend to go for safety and high-quality," he explains. Typically, that means U.S. Treasuries. But because the Treasury is retiring debt, Gross believes that U.S. Treasuries are too pricey. So he says he has gone for the next best thing by putting a 60% share of the PIMCO Total Return Fund, the world's largest bond fund with $36 billion in assets, in Ginnie Mae, Fannie Mae, and Freddie Mac mortgage-backed securities. He notes that these AAA securities have implicit government backing but yield about 1.6 percentage points more than comparable Treasuries.

THE MUNI CASE. For investors in high tax brackets, municipal bonds make the most sense. Recently, AAA insured municipal bonds maturing in 10 years yielded 4.78%. At first glance, that yield doesn't seem impressive. But for investors in the 36% federal tax bracket, that translates to a 7.46% yield, and for those in a 39.6% tax bracket, the aftertax yield is a juicier 7.91%. The muni payoff is even better in high-tax states, such as New York and California, where there's often no state income tax on muni income from locally issued bonds.

Another decision bond investors must make is whether to buy individual bonds or a bond mutual fund (page 212.) By buying individual issues, you can lock in the yield, as long as you hold the bonds until maturity. Bond-fund yields, on the other hand, aren't fixed. The development of the online bond market has made the process of buying individual issues easier, especially for Treasuries and munis (page 213). For tricky sectors such as junk bonds, a mutual fund may be the better choice.

Investing these days is no easy feat. Indeed, the increased volatility of today's financial markets only underscores why carefully chosen bonds or funds belong in every investment portfolio.By Susan ScherreikReturn to top

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