Bond Pros: Where To Ride Out A Jittery Market

Bond pros are jittery. The bull market culminated in late 1993 with the 30-year Treasury bond yielding 5.75%. Since then, bonds have been relatively flat, trading between 6.25% to 7.25% for the past two years. But within that range, you can still get some stomach-churning volatility. In fact, with the U.S. economy deep into one of the longest economic expansions on record, any news even slightly hinting at rising inflation can send the market into a tizzy. On Oct. 8, when Federal Reserve Board Chairman Alan Greenspan said the economy "has been on an unsustainable track," bond prices plunged, pushing the long-bond yield up 15 basis points, to 6.37%, in one day. Days before, tensions between Iran and Iraq sparked fear of rising oil prices and another yield upsurge.

In these turbulent times, what's a fixed-income investor to do? Bonds belong in nearly everyone's portfolio to add current income and offset the risk in the equity portion of the holdings. Because it's difficult to buy small lots of bonds to build a diversified portfolio in the $21.5 trillion market, most individuals prefer to stick with bond funds.

NEAR-TERM BEARS. And what are the top fund managers doing now? A BUSINESS WEEK survey of 25 of the nation's best-performing bond fund managers finds that the majority were bearish in the short term but bullish in the long term. Many say they could see higher bond prices and the yield on 30-year Treasuries falling to the 5%-to-5.75% range in the next three to five years. Most expect the Fed to raise rates moderately, by a quarter point, from the current 5.5%, in the next six to nine months. This would be in response to an expected slight rise in the inflation rate, now 2.2%.

Their buying strategy now is to stick with the highest-quality corporate issues and U.S. government and agency bonds. That should tide them over until the economy slows a bit and the market rallies, perhaps in late 1998. If this consensus is correct, and you can stand some volatility while the market sorts things out, it may not be a bad time to buy bonds or funds now for the long term.

To find the top bond fund managers, we asked Morningstar to search for the highest five-year total annualized returns in three classes of bond funds: corporate, government, and municipal. We looked at two time frames for each group: long term (maturities of 10 years or more) and intermediate term (4 to 10 years).

After culling the best performers in the six categories, we picked those funds with managers who have been on the job four years or more and earned Morningstar ratings of three stars or better (table, page 178). While most funds earned four or five stars for their performance after adjusting for risk, the highest-rated long-term government funds had only three. That's because these funds are highly volatile relative to the rest of the bond fund universe, since they mirror interest-rate swings. We interviewed three to five of the top-performing 10 managers in each category and asked them to forecast the 30-year Treasury yield and federal funds rate through 1998, as well as the inflation rate and estimated low yield on the long bond over the next five years.

For our best buy list, we eliminated funds that were closed to new investors, charged loads, had 12b-1 marketing fees and annual expenses a lot higher than the average for each group, or required an initial investment of more than $5,000 (table).

Some bond bulls think Greenspan's micromanagement of inflation will be enough to cool the economy. "There is the potential to see inflation around zero to 1% long enough to drive long-term bond rates down to 5% in the next two to three years," says Fredrick Quirsfeld, manager of the American Express/IDS Bond Fund. "But first, we need an economic slowdown to take a little froth out of the system."

Other bond bulls suggest the market can rally without an economic downdraft. They contend the U.S. can continue to see strong growth with low inflation. "The inflation rate today is the same as it was in the 1960s, but the long-bond yields then were 100 basis points lower," says bond bull Tom Kenny, director of the Franklin municipal bond department, adding that we can return to that point with no trouble. He argues that increased competition in the global economy makes companies reluctant to raise prices, because someone else could sell their products more cheaply.

This competitive free-for-all will reverse inflationary pressures and produce disinflation and even some deflation, says David Baldt, director of fixed income for Morgan Grenfell Capital Management. That would result in a bond rally with lower yields. "Periods of mild deflation indicate a stronger bond market," agrees Andrew Engel, a research analyst at the Leuthold Group, an independent economic research firm in Minneapolis. He studied bond yields and deflationary periods going back 204 years.

Bulls also note that Treasuries are in demand in the U.S. and overseas at a time when supply is dwindling because of the shrinking federal deficit and lower financing needs. U.S. Treasuries look attractive from a global perspective. Yields for long bonds in Germany and Japan are 5.5% and 1.6%, respectively, compared with 6.4% for the U.S. long bond. "Increased demand could drive long-bond yields lower," says Daniel Fuss, manager of Loomis Sayles bond fund.

But bond bears such as Robert Rod-riguez, manager of FPA New Income, thinks inflation, interest rates, and yields are on the way up. "For the long bond to move below 6%, we would need to have a major structural change," such as reining in entitlement outlays and continued low inflation. He recently put 10% of his $500 million fund into Treasury's Inflation Protection Securities (TIPS), the Treasury Dept.'s "inflation-indexed" bonds introduced last January. "It's a defensive move," says Rod-riguez, who expects 7% long-bond yields and 3% inflation in the next 18 months.

PALTRY. Indeed, nearly all the pros polled agreed it's extremely difficult to find value in bonds right now. They are especially concerned that yields on junk and other lower-quality bonds are no longer high enough to compensate for their risk. Take two recent issues. One was a below-investment-grade, unrated security brought to market by the New Jersey Economic Development Authority for a retirement community. It was priced to yield 6.08%. The other was an AAA-rated Alaska State Housing Finance Corp. bond priced to yield 5.8%. That's a paltry 28 basis points between the junk and the high-grade credit. The spread differential a year ago was 100 basis points. "When spreads are this narrow, there isn't much advantage to buying anything but Treasuries," says William Gross, manager of the Pacific Investment Management Total Return funds.

Other bond fund managers, however, are more sanguine than Gross about finding value. Jeffrey Koch, manager of the Strong Corporate Bond fund, is buying higher-grade junk bonds that he expects will be upgraded to investment quality. Among those are Teekay Shipping and Fresenius Medical Care. "There is significant price appreciation when bonds cross over," says Koch. Loomis Sayles's Fuss, meanwhile, recently invested in Canadian provincial and New Zealand government debt. "The currencies are cheap, and the yields are higher," says Fuss. He's also looking for higher yield among stronger companies that are surviving the currency crash in Southeast Asia. "But you have to be careful," he says.

Of course, what these bond managers do as portfolio directors may be difficult for you to emulate. But whether you're interested in building your own bond fund portfolio or choosing a mutual fund, you should invest for the long term. Pros don't expect the market's whiplash volatility to last forever.

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