Sweet Yields Are Starting To Make Bonds Look Very Tempting

Now may be the time for bond investors who remained on the sidelines during the great bond crash of '94 to start creeping back into the market.

Many economists and fixed-income experts offer this advice, even though they expect the Federal Reserve to push short-term rates up by as much as 200 basis points or more by mid-1995.

So why even think about bonds if interest rates are headed still higher? The simple answer is yields. Yields on 2-to-10-year Treasuries are currently about five percentage points higher than the rate of inflation, now running at about 2.7% annually. That means that even if short-term rates keep rising, further eroding principal, investors in short- and intermediate-term fixed-income securities will be better off than if they had stayed in money-market funds yielding an average of 4.74%. "1995 will be the year of the coupon," declares Ian A. MacKinnon, fixed-income chief at Vanguard Group.

A PEAK? Fixed-income specialists, though, caution investors against trying to outguess the market by plunging back in when they think rates have peaked. The better strategy, they say, is to seek a good average yield by adding to portfolios every month over the next year or so. Many strategists think two-year Treasury notes, or fixed-income funds with a similar duration, are a good bet. They yield just 17 basis points less than five-year notes and are less likely to be whipsawed as rates rise. In fact, some experts, pointing out that further hikes in short-term rates could dampen inflationary expectations and drive down long-term rates, suggest using the averaging technique to create a "barbell" portfolio, consisting of 2- or 3-year securities on the one end and 10-year securities on the other. That way, investors can position themselves for capital gains when and if long-term rates fall without exposing their entire longer-term portfolio to principal erosion should the opposite happen. "Late this year or early next year is the time to start nibbling away," says Leslie J. Nanberg, head of fixed income at Massachusetts Financial Services (MFS).

While most economists agree that short rates will rise, they are divided on how much the Fed will have to tighten to keep inflation in the desired 2.5%-to-3% range. In one camp are those, such as Paul Mastroddi, economist at J.P. Morgan & Co., who believe that the continuing vitality of the U.S. economy hasn't yet been reflected in the inflation numbers. Moreover, he predicts that U.S. exports, which have been growing at a 10% sustained annual pace, will surge when the European and Japanese economies begin to hit on all cylinders. That will press already strained U.S. industrial capacity and prompt the central bank to push Fed funds as high as 8%. "The economy's still galloping forward," he says. Mastroddi thinks the long bond will top out at 8.5% by midyear and decline to 7.5% in 1996. In 1995, he says, a higher-than- expected Fed funds rate could produce an inverted yield curve for the first time since 1989. Robert T. McGee, chief economist at Tokai Bank, concurs with Mastroddi on short-term rates but says: "We'll probably see a 9% long bond before it's over." Accordingly, he'd wait until the 30-year Treasury hits 8.5% before buying longer-term issues.

In the other camp is Allen L. Sinai, chief global economist at Lehman Brothers Inc., who thinks that impressive productivity gains, the Fed's aggressiveness, and declines in federal spending should offset the inflationary effects of an export boom. He expects Fed funds to hit 6.25% by April, and for the 30-year Treasury bond to reach 8% to 8.25% in the first quarter and fall to 7.5% or lower later in the year.

After 2- and 10-year Treasuries, some think that longer-term municipals are very attractive--the fiasco in Orange County, Calif., notwithstanding. Margaret D. Patel, portfolio manager at the Advantage funds, favors Ginnie Maes, which are yielding one point more than 10-year Treasuries with just half the volatility, she says.

Sophisticated investors prepared to do some homework should consider collateralized mortgage obligations (CMOs), which are trading at bargain prices. According to Michael R. Marceda, vice-president at Halpert & Co., a Milburn (N.J.) bond firm, the plain vanilla CMOs were beaten up along with the more exotic ones in the spring 1994 bloodbath. The "cleaner, stable-type bonds that don't fluctuate widely are trading at unheard-of levels," he says.

High-yield bonds are still a good buy compared with investment-grade issues, though spreads between junk and Treasuries have narrowed in the last few months, says Kingman D. Penniman, head of high-yield research at Duff & Phelps Corp. Experts generally advise individuals against buying single issues. But Bradley C. Tank, portfolio manager at Strong Funds, likes Viacom Inc. and Healthtrust Inc., which has agreed to be acquired by Columbia/HCA Healthcare Corp. Both are candidates for upgrades, he says.

HEDGES. Some see pockets of opportunity next year in the international bond markets. But experts say that because the U.S. dollar is expected to strengthen, investors should stick to funds that are hedged against that possibility. Brady bonds, especially the Mexican variety, look promising, because many expect Mexico will soon be blessed with an investment-grade rating. And Margaret R. Craddock, vice-president at Scudder, Stevens & Clark Inc., likes Australian and New Zealand issues and thinks a one-notch upgrade is in the cards for both.

Now may also be a good time for long-term investors to consider 10-year zero-coupon Treasury bonds, which can be bought for about $460 per $1,000 face value, resulting in a yield of nearly 8%. Because zeros tend to be volatile and are taxable even though no income is received until maturity, they're best for investors "who want to put them away [in a tax-exempt retirement account] and forget it," says MFS's Nanberg.

Contemplating these alluring opportunities for 1995 may help investors forget the bond massacre of 1994.