Gold In The Bond Minefield

Amid the danger, intriguing chances to buy bonds cheaply

Bondholders are suffering through the worst year for fixed-income investments since the bleak days of 1994. With the red-hot economy now fanning inflation fears, bondholders are on the wrong side of the Federal Reserve, which has hiked interest rates twice this year. Making matters worse, the carnage from last fall's market meltdown has prompted many Wall Street firms to cut their exposure--creating wider spreads and illiquid trading in many bonds. And junk-bond defaults have climbed to near-record levels. Not surprisingly, a recent Market Vane poll of some 70 investment advisers found only 19% bullish on U.S. Treasuries. "This market feels awful, trades horribly, and could still go lower," says Richard Stevens, portfolio manager at Colonial Management Associates in Boston.

With September's consumer price index report pushing the year-over-year inflation rate above 2.6%--the highest annual increase since March, 1997--many experts believe the Fed will hike rates at least once in the coming months and perhaps twice. But any savvy investor knows that opportunity lurks in a crisis. And many of the bond pros surveyed by BUSINESS WEEK believe the recent upheaval has created some intriguing chances to buy cheaply. "If you know how to step through the minefield, there's never been a better time to be a bond buyer," argues Michael Millhouse, vice-president and chief investment officer for fixed income at Loomis Sayles. Indeed, Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, N.Y., believes the Fed will succeed in slowing the economy by early next year. That would set the stage for a bond rally that could push down yields on 30-year Treasury debt from the current 6.36% to below 6%.

Gregory W. Lobo, senior fixed-income portfolio manager for HGK Asset Management in Jersey City, N.J., is finding especially good value in one corner of the Treasury market: so-called off-the-run debt, older notes and bonds whose maturities now fall in between the most recently auctioned 5-, 10- and 30-year bonds. Off-the-run bonds usually trade at yields just slightly above recently auctioned Treasuries. But thanks to the current liquidity crunch, some off-the-run securities are yielding a quarter-point or more above similar maturities that were just auctioned. Lobo notes that 10-year Treasuries maturing in October, 2006, are now yielding 6.47%, vs. 6.16% for the 5-year notes and 6.25% for the 10-year bonds that Treasury sold just this past August. "You're getting an extra quarter-point return and shortening your maturity by three years," notes Lobo.

Another way to play Treasuries is to invest in the inflation-indexed bonds the government began issuing two years ago. These inflation bonds make special payments each year equal to the change in the CPI. Through Sept. 30, they have returned 2.4%, ranking them among the top plays in domestic fixed income. Yet despite that modest rally, 10-year inflation-protected bonds, commonly known as TIPs, still will have a total return of a minimum 6.7%, assuming a rosy scenario in which inflation averages 2.1% annually over the next decade.

Bond mavens say even bigger bargains await investors willing to plunge into municipal bonds. To be sure, many who took a flier after last fall's market plunge have seen their bet collapse as many munis have gone into free-fall. But at current low levels, they're "one of the more screaming opportunities out there right now," argues Ted Neild, managing director for Chicago-based Nuveen Investment Advisory.

Given their preferred tax status--they are exempt from federal as well as home-state taxes--munis have traditionally traded at a tax-adjusted discount to Treasuries. But a flood of issues from borrowers looking to beat any Y2K market problems, coupled with heavy redemptions from small investors spooked by the rise in rates, has created an anomaly. Munis now trade, on average, at 96% of the yields of comparable Treasuries. For investors with a combined 40% state-federal tax burden, many munis now offer tax-equivalent yields above 9%. "Over the next couple of years, a 9% bond just might outperform the S&P 500," Millhouse notes.

Marilyn Cohen, chief executive of Envision Capital Management, a Los Angeles fixed-income management firm, likes Niagara Mohawk Holdings' 7.75% notes that mature in 2008. They now trade with a yield to maturity of 7.8%. In addition to the interest payments, Cohen is betting the New York utility will enjoy further upside if its debt is upgraded by rating agencies next year. "They're doing everything right: paying down debt and getting their balance sheet in order before deregulation occurs," says Cohen. Other favorites: Delaware Transportation Authority's 7.9% bonds of 2009, now yielding 5.5%, and Massachusetts Water Resources Authority's 6.5% notes due in 2015, trading at 4.6%.

Investors nervous about picking a single muni issue should note that the bargains are equally plentiful in closed-end muni funds. They are trading on stock exchanges at average discounts of more than 5% off their underlying asset values (table). "I haven't seen a buying opportunity like this in four or five years," says Thomas Herzfeld, a Miami-based adviser who specializes in closed-end funds. Among his favorites are Dreyfus Strategic Municipals, Colonial High Income Municipal Trust and, among taxable funds, Lincoln National Income Fund. All trade at more than 10% below net asset value.

DEFAULT DANGER. The footing is a little trickier in the corporate market--particularly in the high-yield sector, where defaults are running at the highest level since the 1991 recession. According to Standard & Poor's (like BUSINESS WEEK, owned by The McGraw-Hill Companies), more than 57 issuers had defaulted on $15.5 billion in debt as of September--an indication that lending standards may have been far too generous in recent years. Given that the defaults are occurring while the economy remains strong, advisers caution that they will only rise when the next recession arrives.

Still, rewards abound for investors willing to stomach risks. Bond managers recommend buying the bonds of companies in such sectors as telecommunications and energy. Among investment-grade bonds, Colonial's Stevens has been buying debt of such energy companies as Occidental Petroleum, Union Pacific Resource Group, and Valero Energy, three companies whose debt hasn't fully reflected the rebound in oil prices. His favorite: Valero's 7.38% note maturing in 2006, which now yields 8.25% in the secondary market. "As long as oil stays between $18 and $22--which I think it will--these bonds offer good values," says Stevens.

In the high-yield arena, Margaret Patel, a portfolio manager for Pioneer Funds, likes NextLink Communications' 10.75% bonds maturing in 2009, which are now yielding a plump 10.55%. Patel notes recent studies showing that alternative local phone-service providers such as NextLink are capturing half of all new business customers from the Baby Bells. Is this a riskier bet than Treasuries? You bet. But in today's shaky bond market, you'll have to shoulder some risk to see any payoff.

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