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Bad Time for Bonds? Not If You Know Where to Look

Wednesday, 16 Feb 2011 | 11:09 AM ET

With stocks on a roll, inflation on the prowl and government debt under the heat lamp, these are not exactly heady days for bonds.

That's just fine, though, for fixed-income pros, who think that the black eye for the debt markets will provide opportunity for investors willing to dig a little and find value despite the rising-rate environment.

Rising rates generally are considered bad for bonds as corresponding inflation eats away at the value of fixed-income investments. But those yield increases also present opportunity, albeit with some risk attached.

"When one part of the stock market is out of favor, what part of the market should we be invested in? It's the same in the bond market," says Jim Sarni, managing principal at Payden & Rygel in Los Angeles. "Just because there's a risk of rates rising, that does not mean the baby goes out with the bathwater."

Bond experts are circling around several key areas in the market.

Among the most popular—even as rates rise—are high-yield corporate bonds, which will provide a decent return over Treasurys.

"The downside risk is very limited from a fundamental perspective," says Matt Toms, head of US public fixed income investments at ING Investment Management in New York. "You could experience market volatility like any product, but we think the fundamentals are quite strong."

Bank loans also are likely to be in favor, both in mortgage-backed securities and collateralized loan obligations. Both classes took a beating during the credit crisis and subsequent collapse of the financial system, but are in the crosshairs for investors now that consumers are beginning to show signs of recovery.

Finally, global bonds are attracting a lot of attention, particularly as a diversification tool should inflation intensify and economic recovery prove to be uneven among leading nations.

So while Treasury and municipal debt likely will be out of favor this year, investors looking for bonds to balance their portfolios should have places to turn, so long as they look carefully.

"It's definitely more important to be selective. We've probably seen the low in Treasury yields, so you have to be more selective in that respect," says Joe Portera, manager of the Hartford Strategic Income Fund. "The economy continues to grow, the chances of a double-dip have receded into the background. Credit should do well, but you have to pick and choose where you want to be."

For Portera, the best opportunities in high yield will come in utilities, gaming, the auto sector and energy. He also likes emerging markets, in particular minerals and mining, which he calls "the China play," referring to the nation's expected growth and build-out needs.

He also likes banks, following a familiar theme among other pros that because loans are priced according to the London Interbank Offering Rate, or LIBOR, they will offer better spreads than Treasurys.

"If you're in the camp that the Fed is likely to start pricing in interest rate increases, or in the camp that inflation may rear its ugly head and the Fed is going to be compelled to raise interest rates in 2012, banks offer some protection," Portera says.

Yet another familiar theme cutting across the asset class is that investors now ought to start looking for yield more than capital appreciation as rates increase. Bond prices and yields move in opposite directions.

"We are in an environment in 2011 and that may carry into 2012, where yield is going to be the dominant source of that total return," Sarni says. "Breaking down that linear relationship that exists between bond prices and yield movement, to the extent that one can do that in a bond portfolio today, is going to be very advantageous. If you can do it without significant sacrifice of yield, that's even better."

Sarni sees four themes playing out in the bond market that will help investors capitalize on upward yield movements and downward price pressure: focusing on yield instead of capital appreciation; going to longer-dated bonds to get yield but protect against volatility; finding solid credit-related debt; and investing in bonds not closely correlated to government yields.

As for municipal debt, the debate continues to rage.

Trader's Buzz
A check on the markets, with Jessica Hoversen, MF Global.

Noted banking analyst Meredith Whitney created a major stir in the fixed income market when she predicted that 100 or more local governments will default on their debt, causing more than $100 billion in losses.

While the severity of her prediction is in the minority among her colleagues, even those who disagree advise great care when investing in munis.

Bonds issued "for an essential public purpose" such as sewer and electric systems and toll bridges likely will do well, while munis attached to some type of public works project that is expected to generate a return—Harrisburg, Pa.'s failed incinerator issue as one example—are more dangerous, Sarni says.

As for global bonds, ING's Toms recommends "a diversified basket of exposure outside of just domestic markets." Should inflation hit, for instance, he says the US likely will be more impacted than other global economies because of its current monetary policies.

Indeed, the extent to which interest rates will be influenced by future Federal Reserve decisions is weighing on many fixed income investors' minds, but not so much as to drive an exodus from the market.

"We expect growth to be relatively robust in the US, better than we've seen," Portera says. "A lot of it's going to be led by business investment and external demand. We're getting global growth, and it continues to be quite robust."

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