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Can Bonds Score a Repeat Performance After Big 2009?

The bond market will have a tough act to follow for 2010, and many investment professionals think this year's stellar returns will not be duplicated.

But any investment class would have a tough time with delivering an encore for such a performance: While stocks got all the sexy headlines during 2009, bonds were stars in their own right.

As such, even though bonds, particularly the high-yield variety, likely won't repeat this year's gains, there will be areas of growth for investors looking both for return and to protect principal.

"Things won't be quite as profitable for the bond market as 2009," said Bill Walsh, president of Hennion & Walsh in Parsippany, N.J. "People who are looking for safety and income and definite cash flow, it could be a benefit to them. You're definitely going to have an appetite for safety."

Investors across an array of bond choices had a nice year to say the least, with the Morningstar Core Bond Index up 6.5 percent.

Even as the equity markets were gaining 20 percent, multiple areas of the bond market saw yields easily eclipse that.

Another Good Year for Corporates

Tops in the field were high-yield corporate bonds, which returned nearly 55 percent on the year as credit spreads tightened and offset the ever-widening yield curve in Treasurys. Corporate bonds as a group gained 18.3 percent, according to Morningstar.

Most analysts see corporates continuing to perform strongly in 2010, primarily due to forecasts of declining defaults and the ability to go to market to raise capital.

Analysts at Bank of America-Merrill Lynch are projecting the default rate to fall to 4.6 percent, while UBS forecasts a similar drop to the 5 percent to 7 percent range from 2009's 12 percent.

Though such a gaudy return would be hard to replicate, analysts still see a robust year for high-yielding corporate bonds.

"We expect more companies to raise public equity financing to help repay their debt and delever balance sheets, providing a favorable fundamental backdrop for the (high-yield) market in 2010," BofA-Merrill analysts Jeffrey Rosenberg and Oleg Melentyev wrote in a note to clients. "The improvement in HY issuer fundamentals and continuing favorable liquidity conditions are going to translate into significant improvement in default rates."

UBS was a bit less sanguine about the prospects for corporates but nonetheless optimistic, noting the changes in upgrades and downgrades from industry rating agencies.

Where the ratio of upgrades to downgrades was 1-to-9 during the worst of the credit crisis, that number has dropped to 4-to-6 and should be even-up in 2010, UBS said.

"While much of the spread compression associated with an unwinding of the most acute phase of the credit crisis has been realized, corporate bonds will continue to benefit from a general improvement in overall credit conditions," the firm wrote in its 2010 outlook. "The vicious cycle of a crisis-driven surge in corporate defaults as companies were unable to roll over financing is now giving way to a virtuous cycle of declining defaults as credit markets continue to normalize."

Other leading performers in 2009 included emerging market sovereign bonds (up 27 percent), Treasury Inflation-Protected Securities, or TIPS (13.3 percent), investment grade corporates (19.7 percent) and municipals (14 percent).

Yes to Munis, No to Treasurys

Two recurring themes among analysts outside the preference for solid corporates are a tendency toward munis and away from Treasurys, which was one of the few classes for the year that saw a negative return. US debt had a negative 2.4 percent return after gaining 14 percent in 2008, according to data from Merrill and UBS.

"By mid-year the Fed is going to have to start increasing rates," said Roy Williams, CEO of Prestige Wealth Management in Pennington, N.J. "If I want to be in government, I'd rather be in TIPS than traditional government bonds. At least in that space you're not going to get walloped as much as interest rates go up."

Keep Your Windows Short

Williams echoes another theme: With economic uncertainty and government fiscal excess on the prowl, bond investors should keep a short window.

"We're keeping our duration at four years. We're probably going to compress that a little further down to about three years," he said. "Don't place bets right now. Have a tactically allocated portfolio."

Municipals, meanwhile, should provide return again even as large states like California find themselves in deep financial trouble.

"In the municipal world, you've got to look at how high rates can really go," Walsh said. "If the economy still isn't doing that well, I don't think you will see a huge jump in interest rates. You could still see some budget problems with municipalities, but I wouldn't we afraid."

UBS also said municipals will provide income, but "total return opportunities seem limited."

"We expect continued credit pressures on state and local governments issuers, less tax-exempt supply and looming increases in marginal rates to be key market drivers," the firm said. "This suggest a tug of war between weak credit fundamentals and supportive technicals."

Indeed, avoiding risk and protecting cash positions is likely to be a strong theme going forward into the new decade.

Winterizing Your Portfolio - A CNBC Special Report
Winterizing Your Portfolio - A CNBC Special Report

"Suffice it to say, we believe that the dominating focus will be on capital preservation and income orientation, whether that be in bonds, hybrids, hedge fund strategies, and a consistent focus on reliable dividend growth and dividend yield would seem to be in order," noted economist and market pessimist David Rosenberg, of Canada-based Gluskin Sheff, said in his year-ahead outlook.

"[O]ne conclusion I think we can agree on is the need to maintain defensive strategies and minimize volatility and downside risks as well as to focus on where the secular fundamentals are positive, such as fixed-income and in equity sectors that lever off the commodity sector," he added.

As always, investors should gauge risk by their own needs.

Prestige Wealth's Williams said his firm will stay with about a 45 percent portfolio allocation to bonds, while Walsh said investors will need to look closely at risk tolerance for the year ahead after such a wild ride in 2009.

"We look at it like everybody's different," Walsh said. "What is your objective? I think bonds should have been part of the portfolio in 2009 and I look forward to 2010."

Williams' outlook for further bond buying comes even though expectations are mostly lower for the group in the year ahead.

"The key driver of performance (in 2009) was a massive tightening in credit spreads, from historically wide levels that more than offset the rise in benchmark Treasury yields," UBS said. "Across the board, we generally believe bond returns are apt to be significantly lower in 2010."

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