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Bonds: Backing The Right Horse

Where to Invest -- The Investment Spectrum

Bonds: Backing the Right Horse

Bonds could be a great bet--but not just any bonds

It finally looks as if the Federal Reserve will ease interest rates to shore up a sputtering economy. That's great news for bond investors. "We expect bonds to rally," says Sung Won Sohn, chief economist for Wells Fargo & Co.

But don't expect all bonds to behave equally. Over the past year, the bond market has been bipolar, with U.S. Treasuries performing smartly while corporate and high-yield bonds sagged. As the economy slows, worries about waning earnings will weigh down corporate and high-yield bonds. Meanwhile, U.S. government and other supersafe bonds figure to flourish against a backdrop of moderate economic growth and a tame inflation rate. Owners of high-quality bonds should get some price appreciation atop their yields.

U.S. Treasury bonds probably won't be the best high-quality choice, however. Treasuries have already had a big move, thanks largely to Uncle Sam's using some of the budget surplus to retire debt. You'll get more bang for your buck from Treasury Inflation-Indexed Securities (TIPs), government agency bonds, and municipal bonds.BIG TIPS. The best approach for 2001 is two-pronged--build a portfolio from two extreme positions in the bond market, a variation on what bond pros call a "barbell," suggests Robert Rodriguez, manager of FPA New Income fund. Usually this is done with very short- and very long-term bonds, but Rodriguez has fashioned a credit-quality barbell with high-grade and high-yield, or junk, bonds.

Rodriguez' biggest bet is in TIPs. These unusual bonds adjust their payout depending on changes in the consumer price index. Recently, TIPs maturing in 10 years yielded 7.2%, reflecting a CPI at a 3.4% rate. Rodriguez, who keeps 44% of his $500 million fund in TIPs, says at this interest rate, these securities are better buys than 10-year Treasury notes as long as the average annual inflation rate stays above 1.7% over the next decade. That's a pretty safe bet, since inflation has historically averaged over 3%. TIPs are also a great way to diversify a bond portfolio because, unlike conventional bonds, they perform well when inflation rises. "They help to reduce your portfolio's volatility," Rodriguez explains.

Another place to get good yield and excellent quality is in mortgage-backed bonds issued by Fannie Mae and Freddie Mac, both quasi-government corporations. These bonds offer yields that range from one-half to nearly a full percentage point above comparable Treasury notes, yet the credit quality is AAA.

For investors in high tax brackets who are seeking safety, investment-grade municipal bonds look like the best deal around. During the past few years of vibrant economic expansion, the credit quality of the nation's states, counties, and cities has only improved, notes David Baldt, managing director for fixed income at Deutsche Asset Management."DIRT CHEAP." At first glance, the 4.4% yield on a five-year, AAA-rated insured muni doesn't look very appetizing. But for investors in the 36% federal tax bracket, that translates into a 6.8% yield; for those in the 39.6% bracket, the aftertax return is 7.3%. The muni payoff is even better in high-tax states such as New York and California, where there's often no state or city income tax on muni income from locally issued bonds. Marilyn Cohen, president of Envision Capital Management, a Los Angeles fixed-income management firm, especially likes the New York City general obligation bonds with a 5.5% coupon and maturing in 2015, recently yielding 5.6% to maturity, and the East Bay California Municipal Utility District 15-year bonds with a 5% coupon and recently yielding 5.08%.

In the corporate sector, some pros believe it's time to start buying. Stephen Kane, co-portfolio manager of Metropolitan West Total Return Bond Fund, says top-drawer corporate bonds--Ford Motor, Bank of America, and Lehman Brothers--are attractive buys. They yield some two percentage points above comparable U.S. Treasuries. The pickup in yield you get from high-grade corporates is even greater than it was during the 1991 recession. That's because the corporate sector has been roiled by an uptick in bankruptcies and the credit collapse of household-name companies such as Xerox and J.C. Penney. "The consensus calls for a soft landing, and corporate bonds have priced in a substantial slowing in the economy," says Robert Auwaerter, senior fixed-income portfolio manager at Vanguard Group.

The fund manager says he is sticking to companies in sectors that continue to do well as economic growth moderates, such as electric utilities, life insurance, pharmaceuticals, and aerospace and defense. Conversely, he is avoiding cyclical industries such as chemicals and basic industries. One corporate bond that's "dirt cheap" is Ford Motor Credit's 77/8% bond of 2010, which recently yielded 7.63%, adds Metropolitan West's Kane.RISK AND REWARD. In the junk-bond sector, rising default rates have spooked investors over the past year. As a result, junk-bond yields have spurted from an average of less than 5 percentage points over comparable Treasuries a year ago to more than 9 now. That's also the highest level since 1991. Deutsche Asset Management's Baldt notes that junk-bond mutual funds, the way most individuals invest in this sector, are yielding 8.5 percentage points more than Treasuries, twice the normal yield spread. "You're well compensated for the risk involved," he says. The biggest danger of buying into the junk sector right now, he says, is that prices will go still lower. But that's not likely to happen unless the economy slips into a recession, he adds.

Investors learned in 2000 how rewarding--and punishing--the debt markets can be, depending on which securities they bought. That's a lesson to keep in mind as you map out your strategy for the year ahead.By Susan ScherreikReturn to top

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