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Low inflation and stable rates may hook buyers

The bond market was the odd man out in 1996. In 1997, however, bonds may prove more popular. With inflation low and interest rates expected to be stable, the inflation-adjusted rate of return is a big draw. And if the stock market dips, or even treads water, bond returns could look even more competitive.

Low inflation, rather than being an aberration of the past few years, may be the new reality as an era of intense global competition leaves companies little room to raise prices. Furthermore, ''a convergence of policies across countries is making economies around the world look more similar,'' says Leslie J. Nanberg, chief fixed-income officer for MFS Investment Management. With less deviation between the fiscal deficits of developed countries, the bond market may be less volatile, he says.

BUY AMERICAN. The risk/reward ratio is tilting in favor of bonds. With the dividend yield of the Standard & Poor's 500-stock index at 2%, stable to lower stock prices mean low single-digit returns. Bonds may not see big capital gains either, but ''for the average bond fund, there's probably 2% to 3% in capital gains in next year's outlook,'' says William H. Gross, managing director of Pacific Investment Management Co. (PIMCO). Add that to the 6%-plus yields on intermediate Treasuries, and double-digit returns aren't far off. Another good reason for diversifying into bonds now: After the long bull run in equities, ''people should make sure they aren't locked into having all their assets being driven by the earnings cycle,'' says Randall Merk, director of fixed-income for American Century Investments (formerly Twentieth Century/Benham).

Low inflation and a tight monetary policy help make the U.S. the place to be, says PIMCO's Gross. ''Investors can move out from money market funds, with a relatively high degree of safety, into something longer-dated offering a higher yield,'' he says. Gross suggests an intermediate bond fund, ''even a government mortgage fund yielding 7.5% rather than the 4.5% of a money market fund.'' He likes Vanguard's Fixed-Income GNMA Fund.

If interest rates fall, GNMA funds can take a hit as mortgages are prepaid. Gross says prepayments could edge up, but that the refinancing waves that took place in late 1993 and late 1995 have narrowed the universe of people who would prepay their mortgages. Morris Offit, of Offitbank, a New York-based private bank and money manager, also likes the mortgage market. ''The 100 basis-point spread over Treasuries that you get on better-quality, government-guaranteed paper is attractive,'' says Offit.

Overdone inflation fears may bring buying opportunities. ''If the market is pricing in an inflation risk, and if the policies in the U.S. are leaning against that risk, that makes it an opportunity,'' says Harold S. Woolley, head of fixed-income investments at Bessemer Trust Co. There are worries other than inflation in the Treasury market, however. Treasuries have been supported by heavy buying by foreign central banks. And, adds Kevin M. McClintock, head of taxable fixed-income for Dreyfus Corp., ''the supply of U.S. Treasuries is low, and we have overseas demand from yield-starved Japanese investors.''

What if those buyers back off? McClintock is sanguine: ''The flood of money has just begun, and it's not just Japan. China may be becoming a big buyer.'' The key will be the strength of the dollar and the pace of economic growth overseas. A significant pickup in the economies of Europe and Japan could mean that more of their capital would stay at home.

Inflation may not eat into returns, but taxes will. ''For most people, munis beyond three- to four-year maturities are attractive relative to Treasuries or corporates,'' says Harold R. Evensky, of Evensky, Brown, Katz, & Levitt, a financial planning firm in Coral Gables, Fla. For investors in the 31% tax bracket, the tax-equivalent yield of a five-year A-rated electric revenue bond is 6.96%; for those in the 39% bracket, it's 7.86%. Evensky suggests that investors ''ladder'' a portfolio using Vanguard Municipal Short-Term, Thornburg Limited-Term, Schwab Short-Intermediate, and Vanguard Municipal Intermediate-Term Bond funds.

BORING, BUT SAFE. Investors venturing outside the U.S. can find good prospects in Canada, New Zealand, and Australia. In Canada, ''inflation is lower, interest rates are higher, and we think it is an appreciating currency,'' says David F. Hoffman, senior vice-president for fixed-income at Brandywine Asset Management. New Zealand's inflation-fighting has also won it converts. ''Inflation got to 2%, and short rates have been moved up to 9% to bring it down,'' says Gross, who is buying two- to five-year bonds there.

What about 1996's favorites, high-yield and emerging markets debt? Arthur Steinmetz, co-manager of the Oppenheimer Strategic Income Fund, says he has to work harder to find value in those areas. He likes emerging-markets plays benefiting from the upswing in the economic cycle of Latin America, such as the bonds of energy and construction companies there. He is also eyeing Treasury bills in Indonesia and the Czech Republic. Indonesian T-bill rates are about 15%. ''There's currency risk, but we feel that diversification is going to be a very good play,'' he says.

In the high-yield market, Offit likes BB-rated corporate debt. ''The spread of BB-rated debt over Treasuries is 250 basis points, but it will be 200 in the next year,'' he says. That's because investment banks are building big research units to follow such debt, and once enough investors appreciate their hidden value, the premium will erode sharply, says Offit.

To many people, bonds seem boring. But safety, steady income, and preservation of principal may look pretty exciting in 1997.

By Suzanne Woolley in New York



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Updated June 13, 1997 by bwwebmaster
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