Should Erratic Rates Scare You Away From Bonds?

After taking a terrible pounding over the past several months, bond investors are understandably hesitant to venture into still-turbulent waters. Most economists feel the water is relatively safe: Inflation seems tamed for now, and the Fed is unlikely to further ratchet up rates any time soon. But a vociferous minority, particularly in the financial community, thinks that the respite will, at best, be brief.

Even the bond bears agree, though, that investors ought to be able to find good yields with relative safety, especially in municipals, junk, "split-rated" corporates, and some foreign issues.

A PLUNGE. Many fixed-income specialists, citing the relative shortage of municipals, recommend buying tax-exempts, which they regard as one of the few values left in the market. For investors in tax brackets of 36% and higher, "munis represent an excellent value," insists James J. Cooner, head of Bank of New York's tax-exempt bond unit. He believes rates will stabilize at current levels and possibly even decline moderately by the end of the year. Adding to the attractiveness of munis is that 1994 demand will outstrip supply. This year, he says, volume of state and local issues will plunge to about $200 billion from $285 billion in 1993. One reason for this is that many local governments, like mortgage holders, moved to refinance their outstanding debt last year at historically low rates.

For an investor in a high tax bracket, he says, the aftertax yield on an A-rated muni is equivalent to a 10% return on a certificate of deposit or other taxable instrument. Because of transaction costs, Cooner advises investors who intend to buy less than $25,000 worth of a new issue at cne time to consider instead a fund that includes issues of their home state, particularly if it's a high-tax state. For well-heeled investors who prefer individual issues, Cooner thinks utility revenue bonds are a good bet because they are usually issued by monopolies that provide essential services. On the other hand, he warns against hospital revenue bonds, even if they're A-rated, unless they're insured or backed by a Housing & Urban Development program. That's because of an excess of hospital rooms and the prospect of radical change in the health-care system.

But not every municipal-bond specialist shares Cooner's optimism. James L. Gammon, president of Lebenthal Asset Management, thinks munis are currently too expensive. "A lot of people have piled on to 7-to-10-year munis, and those have gotten particularly expensive," he says. Although supply is down from last year, he points out that after the New York and California legislatures pass their budgets, large amounts of new issues from those states will flood the market, making munis cheaper. Then, he says, yields on municipals will rise more than on taxables. And because he believes yields on 30-year Treasury bonds could shoot to 8.5% over the next year, "at this moment, cash is the place to be," he says.

There is more of a consensus on other fixed-income investments. Portfolio managers haven't lost their faith in junk bonds. While their enthusiasm has been dampened by the seeming end to low rates, they point out that many junk issues will likely benefit from stronger balance sheets as the economic recovery continues.

Few experts advise small individual investors to invest in single junk issues, but they're less cautious about "split-rated" corporate debt. These are issues that have earned the lowest investment-grade rating from one major rating agency and typically the highest junk rating from another. Because many institutional buyers are limited to issues with investment-grade ratings from both Standard & Poor's and Moody's Investors Service, these issues tend to sell at prices 40 to 70 basis points cheaper than investment-grade issues, says Daniel J. Fuss, head of fixed income at Loomis, Sayles & Co. The firm's top-rated bond fund holds a number of these issues, including USX, Westing-house, and Time Warner.

Global bond prices have dropped dramatically from the highs of last fall, but finding good values now requires much more than a dart board. Among the pros, there's something less than total consensus on the interest-rate outlook in overseas markets. Earlier this year, many money managers thought European bonds would outperform Treasuries. Now, says Tokai Bank Ltd.'s chief economist Robert T. McGee: "You're seeing faster growth in the German economy and comments from Bundesbank officials that downward movement in rates is coming to an end." Referring to Japanese bonds, Fuss says: "The yields are low and the currency is weak. That's a bad combination." But Leslie J. Nanberg, chief fixed-income officer at Massachusetts Financial Services Co. (MFS), thinks there is still room for rate drops in Europe and Japan. With interest rates one to two percentage points higher than in the U.S., "there's real value in those markets going forward."

Theresa A. Havell, director of fixed income at Neuberger & Berman, likes the debt of Australia, Denmark, and Canada. And Fuss has made a substantial bet on the Canadian dollar with heavy purchases of long-maturity Canadian debt. Province of Quebec issues denominated in U.S. dollars are a favorite, Fuss says, because of "abnormally wide" spreads over U.S. securities. These issues, he says, are especially cheap because of what he believes are excessive concerns that Quebec will vote, in upcoming elections, to separate from Canada.

TREAD WITH CARE. Even though there has been a massive sell-off in emerging markets, fixed-income experts are treading carefully. For the most part, they still believe in Mexico and Argentina. Although the long-anticipated upgrade in Mexican debt has not yet happened, portfolio managers remain confident that Mexico will soon achieve its deserved investment-grade status. Argentina, they say, will not be far behind.

MFS's Nanberg says the mutual-fund company is "starting to look at Brady bonds," including Mexico and Argentina. But, he says, "if you're concerned that interest rates are going a lot higher, you probably would not want to be involved with them" --except as a diversification measure.

And with residential mortgage refinancings, and therefore prepayments, slowing to a trickle, some pros now think they've seen light at the end of the tunnel of the mortgage-backed securities market. Once rates level off and volatility abates, says Steven Vielhaber, director of fixed income at BA Capital Management, these instruments "might start to look attractive again."

Not all fixed-income specialists see values in today's markets. The bears argue for a much more defensive posture. Paul D. Mastroddi, an economist at J.P. Morgan & Co., sees gross domestic product growing at a 5% annual clip, U.S. auto makers operating at full capacity, and unemployment falling. Mastroddi believes that the Fed will be forced to push up rates to a level that will keep the economy from growing any faster than 2% to 21/2%. By yearend, Morgan expects the federal funds rate to reach 5.5% and the 30-year Treasury 7.75%. "I wouldn't recommend anyone putting new cash in the bond markets," says Mastroddi.

McGee of Tokai Bank, whose early January forecast of a 6.9% long-bond yield by March 31 put him closer to the mark than most of his peers, generally agrees: "The summer should be good for the bond market. But about the time people get relaxed in the fall, it's going to be rough sledding." He thinks investors in search of safety who don't need their funds immediately should consider buying Treasury notes maturing in two to five years. That way, he says, they will benefit from "pretty good" real returns now and higher yields later as they reinvest maturing notes.

These tones of caution seem pervasive these days among bond mavens. Given the carnage they've been through of late, it's hard to blame them. But the market has fallen enough so that the risk-reward ratio now favors investors seeking to make sophisticated bond plays.

      Bond                    Coupon     Maturity Yield-to-maturity Rating
      ONONDAGA COUNTY            5.4     Apr., 2001      5.10%   AA
      Solid credit, good for highly taxed New York investors
      PUERTO RICO COMMONWEALTH   7 3/4   July, 2000      5.05    AAA
      High quality, triple tax exempt, good absolute and relative value
      USX                        9 3/8   Aug., 2003      8.75    Ba2/BB+
      Attractive spread, improving credit, and candidate for upgrade
      TIME WARNER                9.15    Feb., 2023      9.79    Ba1/BBB-
      Improving credit, available at a deep discount
      CEMEX                      8 7/8   June, 1998      9.30    Ba2/BBB-
      A play on Mexico, lot of downside risk already gone, near investment-grade
      ARGENTINA FRB*      LIBOR +13/16   Mar., 2005      12.52   NR
      Speculative play on battered emerging market but reduced market risk because tied to short-term rates
      PROVINCE OF QUEBEC         7 1/8    Feb., 2024      8.53    A1/A+
      Cheap because of nervousness about upcoming Quebec elections
      *Floating-rate bond     DATA: NEUBERGER & BERMAN; LOOMIS, SAYLES & CO.
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