Bonds: Smarter Plays for Darker Days

Thinking of Treasuries or other fixed-income plays as the stock market sinks? Here's what to look for

by David Bogoslaw

With equity markets reeling lately—and the Dow Jones industrial average delivering its biggest first-half percentage decline in 38 years—investors have fled stocks for the perceived safety of U.S. Treasury bonds.

There's little incentive these days to own government bonds. The yield on benchmark 10-year notes is down to around 4.0%, and five-year notes are at 3.3%, yields near current inflation levels. Amid concern about rising unemployment, tanking consumer confidence, and growing fear that a U.S. recession has been postponed until the end of 2008, the Federal Reserve may not be able to raise interest rates any time soon, even if inflationary expectations start to spin out of control.

In his July investment outlook, published June 30, bond specialist Bill Gross, a managing director at Pimco (AZ), warned that the federal deficit is likely to top $1 trillion on the next President's watch as the government spends big on a housing-market rescue plan and more comprehensive health-care coverage. That could mean depressed interest rates for a long time to stoke an economic recovery, making the outlook for government bonds pretty bleak.

"You have to think outside the box in this type of environment. Today, you can get in trouble if you're locking in 10 years at [rates under] 4%. I think that's a mistake," says Bill Larkin, a fixed-income portfolio manager at Cabot Money Management in Salem, Mass. The weak dollar is another concern that also promises to keep yields under pressure, he adds.

Those Pricey Treasuries

So, what should investors do? Nothing in the near term, says Michael Wallace, global market strategist at Action Economics. "I wouldn't make any dramatic bets or portfolio shifts ahead of the elections, until people get a sense of what the tax policy is going to look like and the fiscal outlook," he says.

Given how expensive Treasury bonds have become, fixed-income portfolio managers recommend owning a diversified portfolio of debt, including investment-grade corporate bonds and asset-backed securities, such as the packaged pools of mortgages offered by government-sponsored enterprises such as Fannie Mae (FNM). Corporate bonds due to mature within five to 10 years are paying two to three percentage points more than U.S. Treasuries of the same maturities.

"Buying sector spreads [the difference between Treasury and corporate yields] makes sense even though the economy is very weak," since corporate bonds are priced low enough to weather the current economic slowing, says Ken Volpert, head of the taxable bond group at the Vanguard Group in Valley Forge, Pa.

Vanguard offers an Intermediate Term Investment Grade Fund (VFICX) made up of 700 bonds with an average maturity of 6.4 years and a low expense ratio of 0.21%. Vanguard also offers an index fund—the Intermediate Term Bond Index (VBIIX)—that contains 1,000 bonds and has an expense ratio of 0.18%. But since it holds Treasury and government agency bonds as well as corporates, its yield is lower, making it "not as pure of a play on credit" as the actively managed fund, says Volpert.

Spread It Out

Don Quigley, fixed-income manager at Artio Global Investors, says his firm has always liked Treasury Inflation-Protected Securities, or TIPS, mainly for their diversification benefits. But at the moment, they aren't as attractive as spread products—industry-speak for higher-yield instruments, such as corporate bonds and asset-backed securities.

"Your best chance of getting a total return over the longer term is by [investing in] spread products. They're higher yield than TIPS, and you get the chance of price appreciation if the spreads move in," says Quigley.

The $1.3 billion Julius Baer Total Return Bond Fund that Quigley co-manages is one mutual fund that gives investors exposure to a wide assortment of corporate bonds, with an expense ratio of 0.69% for the fund's A shares.

Signs of higher inflation around the world are setting off alarm bells for bond investors, who wonder whether the runup in commodity prices—particularly petroleum products—is being driven by supply issues or just speculation.

On the surface, the retreat by consumers in the face of higher food and fuel costs and the drop-off in energy demand is good for bonds, as inflationary pressures may weaken as a result. But fixed-income managers wonder how long the reprieve may last. If speculators get shaken out of the market by lower demand for oil and prices fall sharply, it will be like "hitting the accelerator on the global economy," which would be bad news for bonds, whose prices would fall as interest rates went up, says Cabot's Larkin.

Looking at Ginnie Mae

That's why he says it's important for investors to think about the quality of the debt they're buying and make sure to allocate a portion of their portfolios to bonds that are protected from borrower defaults, such as the pools of federally insured mortgages packaged by the Government National Mortgage Assn., or Ginnie Mae, as well as corporate bonds issued by companies that are doing well in the current economy, such as energy and materials producers.

Ginnie Mae pass-through certificates, which pay investors a piece of homeowners' mortgage payments plus some interest every month, are considered higher quality because the mortgages backing the bonds are taken out mostly by military personnel, whose income and job security are presumed to be better than those of Fannie's and Freddie's client base.

Larkin recommends single–family Ginnie Mae pass-throughs with older mortgages in their portfolios, which have a 5.64% yield and whose mortgages have an average life of just under five years. While most investors assume these bonds will pay them off within five years, Larkin believes they will last a bit longer, with homeowners staying in their mortgages longer due to banks' reluctance to refinance at lower rates.

If the life of the mortgage extends, the yield on the bonds would go up as high as 6%, says Larkin.

Investors do pay a slight premium for Ginnie Mae pass-throughs relative to the cost of Fannie Mae or Freddie Mac pass-throughs, but that premium has diminished since the Fed's bailout of Bear Stearns in March, as investors now assume the Fed won't let the government-sponsored enterprises fail, says Larkin.

Larkin says he chooses the highest credit quality. "It's a rule of thumb. If I don't have to pay for it, I'll take it. Someday you might need it."

Go Long

Investors who can't muster an appetite for higher-risk debt and want to stick with Treasuries should at least stay away from shorter-dated issues, mainly because of inflation concerns. All it would take is for core inflation, which excludes energy and food prices, to climb at a slightly faster pace—0.3% per month for a few months in a row—for the Fed to get concerned enough to raise interest rates to combat it, says Volpert at Vanguard.

"That would be bad for the short end of the yield curve," likely pushing the yield on the two-year note from its current 2.60% to more than 3.0%, he says. That would make the bonds cheaper to buy a year from now.

There's not much risk at the longer end of the market, however, mainly because the Fed will maintain its credibility on fighting inflation, says Volpert.

The bottom line for investors: If you can stomach the added risk of alternatives to government bonds, you'll be paid well for it, and the diversification you get can reduce that risk. And at least you can bide your time until the stock market stops looking so ugly.

Bogoslaw is a reporter for BusinessWeek's Investing channel.