Betting On A Solid Year In Bonds

Bond investors wager '98 inflation will stay tame-making for strong real returns

The bond market isn't known for delivering big surprises. But in mid-December, some market mavens were caught off guard when the yield on the benchmark 30-year Treasury bond dipped and closed below the critical 6% mark for the first time since January, 1996.

That psychologically important event capped a year in which fixed-income investors enjoyed robust returns, thanks largely to worldwide disinflation and a tighter inventory of U.S. Treasury debt, which has resulted from a shrinking budget deficit. For the first time since January, 1994, the monthly flow into bond funds topped $8 billion. Most experts expect the favorable conditions to persist into next year. So, although bond-market returns in 1998 may fall short of their 1997 levels, managers are generally looking for another solid year. Moreover, investors worried about stock-market volatility may want to allocate more of their portfolios to bonds.

Low inflation, of course, is what really drives bond-market returns. "And there's growing confidence that low inflation is here to stay," says Stuart G. Hoffman, chief economist at PNC Bank Corp. Most economists expect the inflation rate, now at 2.1%, to hover between 1.8% and 2.5% for the next few years. Declining industrial commodity prices, the lowest gold prices since 1985, and a strong dollar all point to falling inflation and attractive bond returns. What's more, fallout from the Asian financial crisis could slow the U.S. economy.

FORTRESS AMERICA. A tighter U.S. labor market could upset that forecast. "Domestic forces are working to push interest rates up, while international forces are working to push them down," says Ian A. MacKinnon, Vanguard's fixed-income chief. MacKinnon thinks the Federal Reserve Board is more likely to raise interest rates than lower them. But most analysts disagree; they see rates trending down.

Many fixed-income managers are looking for another rally next year. Bond bull Daniel J. Fuss, managing partner for fixed income at Loomis Sayles & Co., expects economic growth to decline next year by 1.5 percentage points. If that happens, yields on the long bond could fall to 5.25% by mid-June, he predicts. "In a slower economy, I want to be in long, call-protected, and higher-quality-than-normal bonds," he says. William H. Gross, managing director of Pacific Investment Management Co. (PIMCO), who has invested 30% of PIMCO'S $112 billion portfolio in U.S. Treasury bonds, concurs. U.S. Treasuries are "also the vehicle of choice for foreign investors," he adds.

Indeed, compared with government issues elsewhere in the world, U.S. Treasuries are terrific values. Unlike the U.S. long bond, which carries a yield of 5.99%, rates on German and Japanese long bonds are 5.4% and 1.6%, respectively. Of course, there is always a chance that foreigners will stop buying U.S. Treasuries, but it's not likely. "U.S. Treasuries are seen as a safe haven from the Asian currency crisis and the uncertainty over [European Monetary Union]," says Kevin M. McClintock, head of taxable fixed income at Dreyfus Corp. In addition, he says, "the purchase of U.S. Treasuries is part of Japan's solution to bailing out the banking system."

To be sure, investors don't have to invest in long bonds to profit from Treasuries. Paul D. Kaplan, manager of Vanguard's Ginnie Mae fund, points out that investments in two-year Treasuries are yielding a return of 5.7%. "You can still get pretty big, fat yields at the short end of the yield curve now," he says. Stick to short maturities to avoid volatility, Kaplan advises.

While mortgage securities are riskier than Treasuries, investors can find good values in agency bonds such as Freddie Macs and Fannie Maes, says Gross, who oversees a portfolio with a huge $60 billion position in mortgages. They're currently yielding a healthy 100 basis points over Treasuries. Even if interest rates fall, Gross isn't worried about prepayments. That's because he's buying lower-coupon 6.5%-to-7% mortgages and betting that holders won't bother to refinance them.

But not everyone thinks that's such a good bet. Dreyfus' McClintock notes that prepayments are rising, even though mortgage volume typically declines during the winter. And if interest rates fall just 50 basis points below current levels, he thinks the mortgage securities market could perform as poorly as it did in 1993. Investors should look for funds such as Smith Breeden Intermediate Duration Government and Vanguard GNMA that hedge against possible surges in refinancings.

TOUGH SEARCH. Many fixed-income gurus think that munis are also a good buy. "Municipals are cheap and clearly a compelling buying opportunity," says David W. Baldt, director of fixed income at Morgan Grenfell Capital Management Inc. He points out that the ratio of the yield of tax-free AA municipal bonds to that of Treasuries currently stands at an attractive 91%; historically, it has been around 82%. With Treasuries yielding about 6% and long-term munis at 5.4%, the aftertax return on Treasuries is lower than on munis, he adds. Playing the muni market can be done in one of two ways: by buying intermediate or long-term municipal bond funds, such as Vanguard Muni Intermediate-term or Excelsior Long-term Tax-Exempt, or by building a maturity "ladder."

It has been tough to find value in corporates, but Jeffrey Koch, manager of Strong Corporate Bond fund, is buying higher-grade junk bonds that he expects will be upgraded. They are found mostly in sectors that are undergoing consolidation, such as finance and media.

As for high-yield bonds, investors who buy individual issues need to cherry-pick. For the most part, the yields on junk and other lower-quality bonds have not been high enough to compensate for the risk, experts say. But Stephen F. Esser, high-yield manager at Miller Anderson & Sherrerd LLP, a unit of Morgan Stanley, Dean Witter, Discover & Co., argues that "while yield spreads are narrower than they have been, they are still more than you need [in case of] default." Esser especially likes telecommunications issues because of the freedom that companies now have to compete with local Baby Bells. And he recommends cable-television debt, because cable companies are now able to provide Internet access as well as TV service.

The turmoil in the Asian markets has opened up tremendous opportunities in emerging-market debt for investors with strong stomachs. "With news changing hour to hour, the entry point is critical," says Gross. He likes Mexico and Argentina. The latter recently became the first emerging-market nation to issue U.S.-dollar-denominated debt since the global financial crisis began in late October. The Argentine government offered an issue with a new structure, which should bolster investor confidence in the emerging markets.

HIT PARADE. Morris W. Offit, of Offitbank, a New York private bank and money manager, is aggressively buying Brazilian sovereign paper. "The spread opened up to about 600 to 700 basis points, making it a market with real value," says Offit.

Local Russian paper led the hit parade in 1997, with total returns of 21%. "It's likely that 1998 will be even better," predicts Lincoln Rathnam, president of Boston's Schooner Asset Management, an emerging-market fixed-income firm. He also likes Venezuela, which expects to boost oil production from 3 million to 7 million barrels a day.

With all the tumult in global stock markets, many bond gurus--like Dan Dektar, a portfolio manager at Smith Breeden Associates--think that in 1998, "bonds will get back on people's radar screens." Amid the low inflation and solid real returns, it looks as though bonds are well on their way to becoming a choice investment in 1998.

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