Finding the Sweet Spot

When the final returns for 2009 are tallied, they'll likely show that investing in risky bonds was a can't-miss proposition this year: Everything from U.S. corporate "junk" bonds to emerging-market government issues rallied. Will the same hold true in 2010? "I wouldn't expect it," says Chris Diaz, co-manager of the ING Global Bond Fund (INGBX).

Most pros agree that rising interest rates will take a bite out of many kinds of bonds, and soon. As the global economy rebounds, central banks are beginning to signal that the era of near-zero interest rates won't last much longer. Rising rates are generally bad for bonds, whose prices move in the opposite direction of the interest rates the bonds pay. It might seem like a paradox, but the more slowly any given nation recovers from the global downturn, the better the outlook for its bonds will be, because its central bank will be less likely to raise rates.

The European Central Bank, famously hawkish on inflation, seems bent on boosting rates sooner rather than later, despite a struggling financial sector and slow growth in the region. That could make government and corporate bonds in the euro zone a bad bet.

The U.S. Federal Reserve, too, seems likely to raise rates in 2010. The futures market is pricing in an 80% chance of a hike by September. That could lead to a pop in Treasury yields. "It wouldn't take much of a rise in interest rates to wipe out your [bond] income," says Andy Johnson, head of investment grade fixed income at investment manager Neuberger Berman.

Britain, however, isn't rushing to hike rates. Its economic problems are likely worse than those in the U.S., and the British central bank could wait until 2011 before moving rates up, says Jeffrey Elswick, director of fixed-income at Frost Investment Advisors. British government bonds "should be one of the better performers in 2010," he says.

Rising rates could be messy for so-called investment-grade corporate bonds—those rated above BB+ by Standard & Poor's and Fitch, or Ba1 by Moody's Investors Service. (Those rated lower are commonly known as junk bonds.) The 2009 rally has brought yields down sharply. The difference in yield—known as the spread—between a typical investment-grade bond and a comparable Treasury bond is now 1.3 percentage points, just 0.5 percentage points higher than during the credit boom. If interest rates rise too quickly, investors could be left holding pricey corporate bonds that pay only slightly more than Treasury bonds but offer far less safety, a recipe for swift selling.

One sweet spot in corporate bonds may be emerging, however. David Albrycht, portfolio manager of the Virtus Multi-Sector Short-Term Bond Fund, is focusing on the lower end of the investment-grade spectrum. He has been buying bonds rated BBB, including a Principal Financial Group security that matures in 2019 and yields around 6.7% and an Equifax bond that matures in 2017 and yields 5.53%. Even if interest rates rise, he says, the prices of BBB bonds won't necessarily fall. That's because their yields will still be high compared with Treasuries, so there shouldn't be a big sell-off. Investors can achieve a similar result investing in higher-quality junk bonds. Says Albrycht: "There's 24 months left of upside."

SHORT-TERM STRATEGYIf interest rates do rise, so-called floating-rate debt could be one of the better plays, says Derek Brown, director of fixed income at Transamerica Investment Management. These bonds don't have a fixed interest rate; the payments change periodically. The Transamerica Flexible Income fund owns floating-rate bonds from Bank of America (BAC), State Street Capital (STT), and others. If rates start to go up, the interest payments of these bonds will rise with them. The downside? Until rates start rising, these bonds will keep paying next to nothing. The State Street bond paid just 1.25% on Dec. 15; the Bank of America bond, just 0.54%. "When the Fed starts raising rates, these will be a nice thing to have," Brown says.

Another strategy that could pay off: sticking with mutual funds stuffed with short-term bonds so that as rates rise the fund manager can replace the lower-yielding bonds with higher-yielding ones. Start by looking at a fund's "duration," a measure that shows how sensitive its value is to moves in interest rates. If a fund's duration is, say, 1.5 years, it means the fund will decrease about 1.5% in value if interest rates rise 1%, and it will increase 1.5% if rates fall by the same amount. For this strategy, the lower the duration, the better. That could mean choosing a fund like the FPA New Income Fund (FPNIX), which has an average duration of just 1.25 years. Its low-risk strategy paid off in 2008, when it outperformed 86% of its peers. This year the fund is up just 3.4%. (It tends to outperform when others are blowing up.)

More managers are bringing the duration down in their funds. Two top performers this year, the Marshall Short-Intermediate Bond Fund, which gained 27.7% through Dec. 11, and the Putnam Income Fund, which is up 43.6% year-to-date, have also experienced two of the largest drops in duration. The $180 million Marshall fund's duration dropped to 4.92 years at the end of September from 6 years in June, while the $1.2 billion Putnam Income Fund dropped from 6.25 to 5.48. Says Larry Rosenthal, president of Financial Planning Services in Manassas, Va.: "That's the sign of a manager trying to protect his gains."

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