A Fresh Strategy for Bonds

Earnings will come from yields, not price gains

Bonds have beaten stocks for two years running. But don't count on that in 2002. Thanks to the Federal Reserve's 11 rate cuts in 2001, short-term U.S. Treasury yields dipped to their lowest levels in decades. However, in the past six weeks, bond rates have begun creeping back up amid expectations that the economy will recover in 2002.

You can still make money in bonds. But today's environment calls for fresh strategies. "Over the past two years, bond investors earned most of their return from price gains, but 2002 will be about yield plays," says Kevin Cronin, chief investment officer for fixed income at Putnam Investments. William H. Gross, portfolio manager of PIMCO Total Return, the nation's largest bond fund with $48.8 billion in assets, agrees. "Fears of a bear market in bonds over the next 12 months are exaggerated," Gross said in recent comments. "But that still begs the question of how to make money if the bull market is over and Treasury yields are so low," he continued. Gross's solution is to "buy higher yielding bonds that trade at significant spreads to U.S. Treasuries." He figures this strategy should produce a 6.5% to 7% yield, which he notes, is "not too shabby in a world of 1.5% inflation."

So which bonds offer the best yield deals right now? Among high quality bonds, mortgage-backed securities, investment-grade corporates, and municipal bonds are the best bets. These boast solid credit quality but are yielding as much as two percentage points more than comparable Treasuries. Now is also a good time to dip into high-yield bonds, which are yielding more than seven percentage points, on average, than comparable Treasuries. Investors who can stomach more risk should also consider emerging market debt. The well-publicized debt problems of Argentina aside, emerging market bonds have recently been strong performers and yield as much as 10 percentage points more than Treasuries. Amy Falls, global fixed-income strategist at Morgan Stanley Dean Witter, believes both junk bonds and emerging market debt could be big winners if the global economy recovers in the latter half of 2002.

Among high-quality bonds, Putnam's Cronin believes mortgage-backed securities issued by Ginnie Mae, Fannie Mae (FNM ), and Freddie Mac (FRE ) are hard to beat. The issuers' creditworthiness is just below that of the U.S. Treasury, yet yield as much as two percentage points more than comparable Treasuries. Why? Investors haven't bid up the prices because they're worried that mortgage rates will start to decline again. If that happens, homeowners will pay off those higher-yielding mortgages, leading to redemptions of the bonds.

Cronin doesn't anticipate that prepayment problem. He says there are two opposing forces at work that should keep rates steady. On one hand, the economy will strengthen enough to keep mortgage rates from coming down any further. At the same time, he believes that inflation will remain tame enough to keep long-term interest rates from climbing.

William T. Lissenden, a fixed-income strategist at Conseco Capital Management Inc. in Carmel, Ind., recommends blue-chip corporate bonds, which yield an average 1.7 percentage points more than Treasuries. The key: Pick companies with the resources to ride out the recession. One is AOL Time Warner Inc. (AOL ), whose cash flow is getting a boost from its megahit film Harry Potter and the Sorcerer's Stone. Lissenden also favors Sprint Capital Corp. because of the growth potential of its wireless business.

For investors in the loftiest tax brackets, muni bonds still offer the best deals. Bruce D. Simon, chief investment officer at Glenmede Trust Co., advises sticking with general obligation, electric-utility, and most revenue bonds, except hospital bonds, which could be affected by changes in Medicare reimbursements. Yields on top-quality muni bonds are over 90% of U.S. Treasuries for the 1- and 30-year maturities, and more than 82% for maturities over 10 years (chart). What this means is that taxable investors give up little in cash payouts to get tax-free interest payments. For instance, 10-year AAA general obligation bonds recently yielded 4.41%. That's the equivalent of 6.84% in a taxable security for those in the 35.5% federal tax bracket.

For those who want to take some risk, consider munis from the New York City area. Joseph P. Deane, portfolio manager of the Smith Barney Managed Municipals fund, says the bonds of the Port Authority of New York & New Jersey and the Triboro Bridge & Tunnel Authority offer good value. "The prices of Triboro bonds declined sharply after September 11 because investors thought bridge and tunnel toll revenues would fall sharply after the terrorist attacks," Deane says. That has not happened, however, because local tolls haven't been much affected, he says. Triboro Bridge & Tunnel bonds maturing in 25 years are rated AA-, yield 5.48%, and, for New York City residents, are exempt from city, state, and federal taxes.

Some pros believe junk bonds will prove to be the best performing sector of the bond market in 2002. During the past two years, junk bonds were hurt by worries about deteriorating credit quality and even some bankruptcies, but those worries are starting to recede. With the average junk bond yielding 12.92%, or 7.6 percentage points more than Treasuries, Simon says the sector offers a good risk-reward tradeoff. Margaret Patel, portfolio manager of Pioneer High Yield Fund, agrees. "Because yields are so high, you can still suffer some credit losses in individual junk-bond issues but come out ahead of Treasury rates," she says. Patel, however, stresses that junk remains a risky investment. She notes that the junk-bond default rate, recently at 9.8%, isn't expected to peak for another few months. Two areas to avoid, she says, are the telecom and airline sectors.

It's tough for individuals to buy junk bonds because institutions dominate the market and many issues are thinly traded, making it hard to sell them quickly. So look for junk-bond funds with proven track records and seasoned managers. Alan Papier, an analyst at Morningstar, favors PIMCO High Yield, Pioneer High Yield, and the Vanguard High-Yield Corporate funds.

Investors who can take on even more risk should try emerging market debt. Morgan Stanley's Falls believes such debt, especially the bonds of Brazil, Russia, Ukraine, and Peru, will benefit as the global economy rebounds next year--despite Argentina's problems. "The countries we like have sound fiscal policies, and their prospects aren't likely to be impacted by Argentina," she says. Those countries' bonds are yielding 5 to 10 percentage points more than Treasuries. Two top funds in this sector are PIMCO Emerging Markets and Fidelity New Markets Income.

Bonds may not perform in 2002 the way they did in the past two years. Still, as investors have surely learned lately, bonds in your portfolio will go a long way toward protecting your wealth.

By Susan Scherreik

With Lewis Braham in New York

— With assistance by Lewis Braham

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