Best Bets: Time To Be Picky About Bonds

Bond investors need to stick with a selective approach even though the Federal Reserve has calmed troubled waters with its recent easing, experts say. Most see a sluggish economy, though not recession, and retail investors should tailor their ideas accordingly.

“Generally, we’re in an environment of sub-par growth, moderating inflation pressures and an unwanted tightening in credit availability,” says Robert DiClemente, chief U.S. economist at Citigroup Global Markets in New York.

The central bank’s ½ percentage point cut in its discount and federal funds rate on September 18 caused bonds and stocks to rally. But the likelihood of additional rate reductions is up for debate.

“I think the the Fed is encouraged by the markets’ reaction, but there’s not compelling data in hand to move again in October,” DiClemente says. The Fed next meets Oct 30-31.

Dennis Cook / AP Federal Reserve Board Chairman Ben Bernanke delivers the board's Monetary Policy Report to the Senate Banking Committee in Washington Wednesday, July 19, 2006. "The recent rise in inflation is of concern," and possible increases in the prices of oil as well as other raw materials "remain a risk to the inflation outlook," Bernanke said. (AP Photo/Dennis Cook)

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.

Bill Gross

Others advocate taking a look at high-yielding spread products as well. Bill Gross, managing director at Pacific Investment Management Co., or Pimco,, says the loan market is recovering. “Many closed end bank loan funds are selling at attractive yields and, in some cases, discounts to net asset value.” Pimco’s two loan funds yield about 10 percent. “The loan market is regaining its legs and tens of billions of dollars in new funds are being committed to absorb the backlog of commitments for private equity,” Gross says.

As for the specter of inflation, those unnerved by runaway gold, oil and raw materials prices along with a weak dollar may look to the Treasury Inflation-Protected Securities (TIPS) market, which can be tapped directly, www.treasurydirect.gov, or through TIPS mutual funds offered by many investment companies.

“There are some latent inflation pressures that have yet to be dealt with,” says First American’s Kung, who also runs the Inflation Protected Securities Fund there.  “TIPS are a fairly inexpensive way to take out inflation protection insurance.” 

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