End of the Bond Boom?

At the height of the credit crisis, nearly everyone was bullish on bonds.

Experts gushed over "equity-like returns" in the fixed-income sector, advisers recommended bonds for the long haul, and even equity managers were buying bonds. Since December investors have plowed $18 billion into high-yield bond mutual funds, around nine times the amount for the same period a year ago, according to consultants Financial Research. So far in 2009 corporate bonds have rallied 13%, while the high-yield sector is up 41%, topping the 12% gain of the Standard & Poor's 500-stock index.

It may be time, however, for investors to reconsider their love affair with fixed income. Yields on junk bonds have dropped from more than 20% to under 10% during the past eight months, while investment-grade bonds pay one-third of what they did at the height of the crisis. (Bond prices rise as their yields fall.) At current prices, investors may not be well enough compensated for the risk they're taking. "The economic outlook hasn't changed enough to justify the change in price," says Steve Huber, manager of the T. Rowe Price Strategic Income Fund (PRSNX). Individual investors may be late to the game, putting $2 billion in U.S. bond funds during the last week of July, the most of any week this year, according to fund-flow tracker EPFR.

Now many professionals are seeking bargains elsewhere. J.P. Morgan's Private Bank global investment specialist Philip Guarco, who bought investment-grade bonds in January and February, has begun cutting back his position in favor of beaten-down mortgage-backed securities. FPA Crescent (FPACX) fund portfolio manager Steven Romick has been taking profits in investment-grade bonds as well and favors "extremely distressed debt" from companies such as CIT (CIT) and International Lease Finance.

During the credit crisis, Cliff Remily, manager of the Thornburg Investment Income Builder fund, brought his bond allocation to an all-time high of 45%. (He's held as little as 10%.) Bond yields were twice those of dividend yields on equities of the same companies, but had less downside risk. The situation has reversed, and Remily is slowly moving back into stocks. He likes the mortgage real estate investment trusts, including Apollo Investment Group (AINV) and Chimera Investment (CIM). Profits in the sector are expected to improve as the value of the home loans these REITs hold goes up. Many of the stocks have dividends of 8% or more.

All of this isn't to say investors should flee bonds. But returns will likely come from the bond's yield rather than from double-digit price appreciation. For a typical high-yield fund, that means 10%, with an extra one to two percentage points of upside if stocks go up, says Matt Freund, vice-president of Fixed Income Investments at USAA. (The high-yield sector trades more like stocks than bonds.) There could be a three- to five-percentage-point downside if defaults keep rising. And on the investment-grade front, as long as inflation isn't an issue, investors can expect yields to stay around 5%. "The whole object of bonds is to buy, hold, and make interest," says Don Humphreys, president of Voyager Wealth Management in Harrington Park, N.J. "Not to treat them like stocks."

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