Bond markets perform best against a backdrop of very weak growth and low inflation.
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Historically, fixed income has provided a return of two-three percent over inflation, or four-six percent, notes Fran Kinniry, principal, Vanguard Investment Counseling & Research in Valley Forge, Pa. “We’re not in a low-yield environment right now; this is a normal yield environment. You’re getting a 7 percent real return on stocks, (versus about 5 percent on bonds), but the risks on stocks are so much greater.”
A typical investment portfolio might be 50 percent stocks, 40 percent bonds and 10 percent alternative assets (cash, commodities, real estate etc.), varying according to age, goals, risk tolerance and wealth. But within the fixed-income arena, buyers should be picky with their cash.
The recent sub-prime loan crisis underscores the importance of credit quality, especially for the small investor. Those averse to volatility will want AAA or AA-rated debt.
Coupling the quality focus with reduced expectations for Fed rate cuts and niggling worries about energy and food prices suggests investors need to be choosy.
“Investors need to look before they jump,” says Scott Berry, senior mutual fund analyst at Morningstar Inc in Rochester, Michigan. “For fixed income that means expenses and quality.” The range of returns in bond funds tends to be really tight, so a fund’s expenses can make a big difference, Berry notes.
Analysts agree that the summer of turbulence in credit markets caused institutions to dump debt that wasn’t top notch as they switched to a capital preservation mode. Now there’s a realization that the baby got tipped out with the bath water.
“Everything that was not a three-month T-bill was sold in the credit panic,” says TJ Marta, fixed-income strategist at RBC Capital Markets in New York. “Institutions are now starting to kick the tires on the higher quality paper and retail investors should be in a position to ride that wave.”
The fundamentals for investment-grade corporate debt remain pretty good, although there is some caution due to plentiful supply. However, those seeking to pick up extra returns can look to municipals, certain asset-backed securities and these investment-grade and even non-investment grade or high-yield corporate bonds.
“Volatility over the summer has led to a lot of opportunity in municipals as yields have spiked higher,” according to Berry of Morningstar, adding that municipals should be considered even for people not in the highest income-tax bracket.
Wan-Chong Kung, fixed-income portfolio manager at First American Funds in Minneapolis, says investors can consider specific asset-backed securities that took it on the chin during the liquidity crisis.
“We like the higher quality spread products - credit card, auto and commercial mortgage-backeds. They are very high quality, but got dragged down by the credit craziness. Retail investors can earn a nice income over Treasuries with these asset classes,” says Kung, who helps run First American’s Total Return Bond Fund.