Bond Investors Will Have To Lower Their Sights

With most experts forecasting falling rates, high yields will mean higher risk

If you haven't invested in fixed-income securities lately, you're in for a shock. The 30-year Treasury bond is at just 5.8%, not far from its historic low. And there's strong belief that long bond rates could go to 5% or below. That would be a big boon for those who play the capital-appreciation game. But for the yield investor, seeking out attractive opportunities has never been harder.

Despite the low rates, many bond investors stick with conservative government securities. Many others, however, are flocking to high-yield and emerging-market debt. The risks are real, but for those with strong stomachs, the extra three to four percentage points over Treasuries may be worth it.

TUG-OF-WAR. There are many reasons behind the forecast of lower rates, but the most immediate is the Asian crisis. "The 12-month outlook for the bond market is dependent upon the damage in Asia and the damage it inflicts on our economy," says William H. Gross, managing director of Pacific Investment Management Co. (PIMCO), one of the country's largest bond portfolios, with $130 billion in assets. He estimates that Asia's problems could cut U.S. economic growth by half: Asian currency devaluations will reduce prices of imported goods to the U.S. and increase the cost of American exports. As Americans substitute imported goods for domestically produced goods and U.S. manufacturers find it harder to sell goods abroad, the strength in U.S. demand may slow. "That's just what the markets need for a bond rally," says Gross, who predicts a long-bond yield of 5.5% by yearend.

Until that time, the current tug-of-war between deflationary pressures stemming from slowing growth and wage pressures from a tight labor market will be intense, leaving some market-watchers unsettled. "This is the diciest forecast period ever," says David H. Resler, chief economist at Nomura Securities International Inc. But Resler and others still think that a low inflation rate, which he estimates will range from the current 1.6% up to 2.5%, is sustainable even "though the market is slow to adapt," says Resler.

Some bond experts argue that real rates in Treasuries--the Treasury rate minus the inflation rate--are high. Since 1920, real rates have averaged 2.8%, says Philip Braverman, chief economist at DKB Securities. The average inflation rate over the last three years, as measured by the consumer price index, is 2.1%, making the real rate 3.7%. Given Braverman's belief in the likelihood of lower rates in the long-term, he suggests 30-year Treasuries or zero-coupon bonds. Thirty-year zeros will appreciate three times as fast as 30-year Treasuries if rates fall. Although income from zeros isn't distributed, investors must pay income tax. But Braverman argues that it's still a good deal because investors can lock in a higher yield than he expects later on.

Zeros, of course, are for unreconstructed bond bulls. For the less zealous fixed-income investor, it's better to be in a diversified portfolio of intermediate maturity. Ten-year Treasuries are a good bet, because of the likelihood of a declining inventory of U.S. Treasury debt and continued strong demand from foreigners who see U.S. government debt as a safe haven, plus a possible stock slump. Also, U.S. yields are higher than most government issues worldwide: German and Japanese 10-year bonds yield 4.89% and 1.22%, compared with 5.55% for U.S. counterparts.

Mortgages, which are bundled together and sold to investors, are riskier than Treasuries but are a high-quality alternative for yield seekers. When refinancings soar, many mortgages get paid off early. Prepayments hit 50% on some of the faster-paying 8% coupons in the first half of this year. "If the 10-year Treasury rallies 25 basis points from today's 5.55% and remains there, then we could see prepayment rates at a faster clip than 50% in the higher-coupon mortgages," says Dan Dektar, a portfolio manager at Smith Breeden Associates. He recommends investing in bonds with less repayment risk such as the lower 6%- and 6.5%-coupon Ginnie Maes. Investors still get 100 basis points over Treasuries with low prepayment and minimal credit-risk and interest-rate volatility.

Municipals offer one of the few cheap sectors of the bond market. "This environment is about as good as it has ever been," says Ian A. MacKinnon, Vanguard Group's fixed-income chief. The ratio of the yield on tax-free AA municipal bonds to that of Treasuries stands at an attractive 92%. Historically, it has been around 86% for most 20- to 30-year munis. Thomas C. Spalding, a senior investment officer at John Nuveen & Co., recommends buying 15- to 20-year munis because there's plenty of yield without the volatility of the longer-maturity bonds.

The two most popular areas for yield-hunters are junk bonds and emerging-market debt. Junk's payout advantage over Treasuries ranges from 325 to 450 basis points. Adds Leslie J. Nanberg, fixed-income chief at Massachusetts Financial Services, "the high-yield market is healthier, less leveraged, and more diversified than it once was." But buyer beware. Default rates, still below their historical average, are rising, and poorer-quality issues have been coming to market recently. Telecommunications is a popular pick among junk buyers. Nanberg likes COLT Telecom Group PLC, a local, long-distance, and Internet company operating mostly outside the U.S.

TOO RISKY? Fixed-income managers are finding the most yield, and the most risk, in emerging markets. "It's very volatile but it has been the best performer," says Daniel J. Fuss, managing partner for fixed income at Loomis, Sayles & Co. For the five years ended April, the J.P. Morgan Emerging Market Brady Index has returned a cumulative 123%, compared with 38% and 68% for the Lehman Corporate and High-Yield Indexes. Fuss has invested in Thailand, Korea, and the Philippines to get 400 to 550 basis points over Treasuries. Lincoln Y. Rathnam, chairman of Boston's Schooner Asset Management, likes Brazil and Venezuela. But not everyone thinks emerging-market debt is worth the risk of payment suspension or outright default. Kevin M. McClintock, head of taxable fixed-income at Dreyfus Corp., thinks the sector "is overpriced and will continue to be negatively affected by the news flow from Asia."

Almost everyone agrees that finding value in corporate bonds is particularly difficult now. The yield premiums over Treasuries are historically narrow. Jeffrey Koch and John Bender, managers of Strong Corporate Bond fund are buying Delta Air Lines and Riggs National Bank. Earl McEvoy, Vanguard's corporate bond fund manager, likes the insurance industry, where many of the former mutual companies are first-time issuers.

For some fixed-income gurus, asset-backed securities--unlike corporate debt--can hold great value for investors who need to buy short-term debt. Robert Kapito, head of portfolio management for Blackrock Financial Management, thinks asset-backeds offer a big supply of high-quality issues with long histories and low defaults.

In short, bond investors had best lower their expectations or increase their tolerance for risk.