Bearing Down on the Best Bond Plays

Donald Quigley of the Julius Baer Total Return Bond Fund is finding the best values in fixed income overseas

Investors have turned a cold shoulder to bonds so far this year. Prices have dropped after numerous economic reports have shown the economy still has legs, sending the yield on the 10-year Treasury note from 4.6% at the start of the year to 4.84% as of Feb. 2. The strong economic numbers are pushing back market forecasts for the Federal Reserve to lower interest rates from early in 2007 to much later in the year, if at all. And some economists think a rate hike might be in the cards if inflation picks up (see, 1/29/07, "The Fed: A Tilt Toward the Tighter Side?").

The best way to navigate the volatile bond market is to rotate among various areas such as Treasuries, asset-backed securities, and investment-grade corporate debt, says Donald Quigley, portfolio manager of the Julius Baer Total Return Bond Fund (BJBGX). He and his five-member team are also seeing opportunities in foreign markets, particularly Mexico, Australia, and Russia. This strategy has helped his $600 million no-load fund outperform the Lehman Brothers (LEH) U.S. Aggregate Bond index, with returns of 4.79% in the last year, 4.17% over three years, and 7.2% over five years (annualized through Dec. 31, 2006).'s Karyn McCormack met with Quigley on Jan. 30 in New York to get his outlook for interest rates and the best places to invest in bonds. Edited excerpts from their conversation follow:

Why have bonds sold off recently?

Mainly because the economic numbers keep coming in stronger than expected or stronger than what the market was looking for two months ago. Basically, the Fed is less likely to ease rates anytime in the next month or two months. At one time, the market was expecting 125 basis points of moves—that is, easing to 4%—by the end of '07. Now we're not going to get that—or if we do, the numbers over the next few weeks are going to have to be pretty bad for the Fed to start to move by that amount (see, 2/1/07, "The Fed: It's a Goldilocks Economy").

It's not like the economy is showing that much strength. But where is the value if you can buy cash and take zero risk or close to zero risk in a money market instrument, instead of a bond where you have substantial interest-rate risk. That's the difficulty.

How are you investing in this environment?

We aren't taking a lot of benchmark risk in the U.S. But where we think you'll get the best value is overseas. We think you can capture more yield overseas. You're still exposed to interest-rate risk, so we're staying on the shorter end [of the yield curve] in a lot of our investments overseas. Investments that we have more interest-rate exposure in higher duration [longer-term instruments] are Mexico and Australia. We've got shorter-term exposure to Russia, Slovakia, Poland, and Hungary.

What we do is a little different from a lot of our competitors. We don't take a lot of credit risk—we invest only in investment-grade credit. We use our international expertise, and we feel we can broaden our investment horizon by looking at different yield curves. For instance, Poland right now offers a better opportunity than what you're getting in the U.S.

What's your allocation?

We can go up to 40% in nondollar securities, so we can go from 60% to 100% in U.S. bonds. Our natural habitat for foreign bonds is around 20%.

Overall, Treasuries including TIPS [Treasury Inflation-Protected Securities] are about 20% of the fund, mortgages are around 30%, international is 20%, and agencies are about 10%.

What's your outlook for the Fed?

I don't see the Fed doing anything for a while. I do think the next move will be an ease, but not anytime in the next six months. That's because the unemployment situation at 4.5% doesn't say to me that we need to start easing.

The big wild card for me is still, and it's kind of clichéd, is housing. The housing market is not out of the woods. I'm not saying housing prices are going to tank and the national average is going to be down 10%. I don't expect housing prices to go up 7% to 12% every year. I think for the next several years you could see housing prices flat, or a little above or below—you're not going to get the same kind of price appreciation in the housing market. That does cause me concern because the refinancing—using the ATM card out of a house—is closed. If that's closed, is the consumption-driven model still going to be able to be supported in the U.S.? I don't think that's a sustainable model anymore.

With the unemployment level at 4.5%, housing will not get devastated, and the economy doesn't have to get devastated. Housing can take a little more of a dip, but people still have jobs and can meet their mortgage payments.

One thing that's interesting—the asset-backed expert on my team is seeing a trend in the credit derivative swaps (CDS) in the asset-backed market, which is basically based on the home equity market. What's happening is the lower trenches of the CDS market—the triple-B minus—had spreads of 300 basis points over Treasuries, and now they're 500 basis points over. That's because a lot of hedge funds and the faster money crowd are selling—they're going short the CDSs—because this is their best way of betting against the housing market. I'm not saying this is the smart money, but the fast money is leaning in this direction. So people are putting their money where their mouth is, saying the housing market, at least the lower-rated parts of it, meaning the subprime investors—could be in danger.

What's the best opportunity in the bond market now?

Mortgage-backed [securities] have some yield. And if you don't expect the Fed to be dynamic, you can argue mortgage-backed are going to have more value than corporate bonds. I do say that. I don't think mortgage-backed are a home run, but you're going to get on base.

I do have worries about corporate bonds. I think there's value in certain names, and you can do O.K. One of the things we look for is bonds of companies that have M&A or LBO protection. So it's a poison put or a private company, or somehow its capital structure makes it difficult for some kind of takeover to take place, or it's too big. No one can make a run at GE (GE) as far as I'm concerned. And Citigroup (C)—you can't lever the name because you'll blow the business.

Alcoa (AA) had a poison put—this means if there's a takeover and the rating deteriorates, you can put the bonds back to the company at par or 101. [A poison put] doesn't cover all scenarios but does give some comfort. The good thing about them is if companies are issuing them, it makes it harder for the LBO to take place because they have to go into their calculations and figure they have to raise an amount of cash to buy the bonds because they know they're getting it back.

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