Bonds: The Action Slows but Doesn't Stop

There's life in munis and corporate bonds

Bond investors face a tougher environment now that most of the Federal Reserve's rate cuts are over and the economy appears headed for recovery. "The easy money has been made," says Stephen Kane, a co-manager of Metropolitan West Total Return Bond Fund.

Two strategies look most promising. The first involves seeking out Treasuries and municipal bonds with maturities that offer the best relative values. The second focuses on investment-grade and high-yield corporate bonds that stand to strengthen as the economy improves. True, these bonds have rallied, but pros say the debt of financially sound companies still has room to climb.

Because of the Fed's aggressive easing, yields on short-term Treasuries aren't nearly as plump as those on the longer maturities. But you don't have to take the risk of buying 30-year bonds to do well. The best deal in Treasuries is in notes maturing over the next five to seven years, says Jerry Thunelius, head of taxable fixed-income at Dreyfus. The yield gain over shorter maturities is substantial--the five-year note yields 4.75%, while the two gives just 3.98%.

INFLATION JITTERS. In munis, the longer the maturity, the better. David Baldt, chief of Deutsche Asset Management's fixed-income division, says 30-year munis have hardly budged since January while yields on shorter maturities have dropped half a percentage point because of "overblown" inflation fears. For instance, AAA-rated munis maturing in 2031 yield 5.18%, or 91% of comparable Treasury yields. But five-year AAA-rated munis yield 3.7%, only 79% of like Treasuries.

For a little extra yield, try California bonds. Mary Miller, portfolio manager of the T. Rowe Price Tax-Free Income Fund, says the Golden State's munis yield about 0.20 percentage point more than other states'. That higher yield reflects a downgrade in California's credit quality, the result of energy shortages and a slowing economy. Miller sees some risk of another credit downgrade, but she doesn't expect any defaults.

In the corporate arena, investment-grade bonds have an average yield of 6.5%, 1.29 percentage points above that of 10-year Treasuries. True, the yield over Treasuries was nearly twice as high in January, but Metropolitan West's Kane says opportunities remain to get bonds with good yields. He's especially keen on insurer bonds and select credit-card issuers, such as Capital One Financial. The easiest way for individuals to play this market is through a mutual fund. Some funds that own big slugs of high-grade corporates and have solid track records are Metropolitan West Total Return, Western Asset Management Core Bond Fund, and Dodge & Cox Income Fund.

JUNK RALLY? Willing to stomach more risk for richer payouts? Consider high-yield corporates, which recently averaged 13.0%, or 7.76 percentage points above 10-year Treasuries. That's down from a 9-point advantage earlier this year. Still, Martin Fridson, chief high-yield strategist at Merrill Lynch, believes junk bonds will rally modestly in the second half as bond defaults go down. He forecasts the default rate, recently 9%, to fall to 5.5% within the next 12 months.

Of course, the battered telecommunications industry, a huge junk-debt issuer in the late 1990s, has shown no sign of turning up. That's why Deutsche's Baldt warns investors to avoid junk telecom bonds and high-yield funds that have loaded up on them. Two top-performing funds that go light on telecom debt are Northeast Investors Fund and Janus High Yield Fund, says Morningstar senior analyst Eric Jacobson.

In today's climate, you can still find good returns. The key to success: comparing deals before you buy and seeking out opportunities that arise as the economy rebounds.

By Susan Scherreik

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