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BONDS: SO LONG, EASY PLAYSThe Treasury rally may be over, but munis and high-yield bonds could offer good returns
The currency crises that swept Asia, Russia, and Latin America this past summer and fall triggered a mad stampede out of any bonds that were seen as even slightly risky. Money poured into Treasuries, raising their prices and pushing their yields down to levels not seen in a quarter-century. While Treasuries still offer the ultimate safe harbor from the global maelstrom, many experts believe that with 30-year government bonds now yielding 5%--or roughly half the level of a decade ago--the great Treasury rally of the '90s may have run its course. In contrast, there's plenty of room for appreciation in the sectors that fell into disfavor in 1998, including high-yield corporate bonds and municipal bonds. ''It's a fun time to be a bond- fund manager,'' says Michael J. Millhouse, who manages $17 billion in bonds for Loomis, Sayles & Co. ''I'm excited about coming to work and finding bonds to buy.'' The trouble, of course, is that there's a good reason those sectors are cheap: They're vulnerable to another flight to quality by panicky investors. ''The markets are so volatile that it's difficult to have enough confidence to bet the farm on anything,'' notes Ian MacKinnon, fixed-income chief for the Vanguard Group. Continued low inflation and reductions in the official interest rates were good for most fixed-income securities in 1998. True, owners of 30-year Treasuries did the best, with a total return of 17% for the year through Nov. 30. But Lehman Brothers Inc.'s overall government bond index was up a strong 9.6%, and its overall corporate bond index climbed 8.3%. On the downside, Merrill Lynch & Co.'s high-yield bond index advanced only 3.6% through November, and J.P. Morgan & Co.'s emerging-markets bond index declined 12%. The consensus among the bond mavens interviewed by BUSINESS WEEK is that inflation will remain low and official rates will be reduced further in '99. With global contagion likely to slow U.S. growth to roughly 2% next year, the Federal Reserve will be called upon to cut the federal funds rate--the price the Fed targets for overnight interbank loans--from 4.5% to 4% or lower. But absent a complete collapse of the U.S. economy--which no one is forecasting--most bond pros believe that long-term Treasury yields are unlikely to drop much further and could rise. ''We're likely to see lower short-term rates, but long rates are about as low as they can go,'' says Millhouse. A better play in Treasuries may be intermediate bonds--those with 3- to 10-year maturities. WILD CARD. One sector that many experts are bullish on is municipal bonds. Because they're exempt from state and federal taxes, their yields are usually lower than those of Treasuries. But Treasury yields have fallen in the flight to quality, so much so that many long-term municipals are yielding as much as Treasuries. Any investor with a combined 40% tax rate can enjoy an effective yield on munis that's a couple of percentage points higher than the effective yield on comparable Treasuries. For instance, Long Island Power Authority's 5 1/8% bonds maturing in 2022, trading slightly below par, would provide a return for high-net-worth investors equal to that of a taxable bond yielding 8.4%. Other state bond issues worth mining are those from California, Massachusetts, and Texas. And for investors looking to stock their retirement plan, corporate bonds offer even higher returns. The wild card here, however, is how much the U.S. economy softens in 1999. Early in this decade, corporates took a bath as investors began selling in anticipation of widespread defaults. The trick, then, is to pick corporates that are less vulnerable to global contagion. Vanguard's MacKinnon recommends regional banks and electric utilities for taxable accounts. John Bender, co-manager of the Strong Corporate Bond fund, likes Cendant Corp., the Parsippany (N.J.)-based franchising giant that fell out of favor earlier this year due to an accounting scandal at its merger partner CUC International. Bender argues that Cendant's cash flow from its hotel and real estate franchise operations remains relatively stable, which makes the five-year note it floated in November a good value. That note, yielding 7.4% in mid-December, has a ''reset'' feature, so if it loses its investment grade rating, the coupon resets at an additional 1.5 percentage points. Investors with a greater appetite for risk should consider wading into the high-yield pool, particularly since the yield on Merrill Lynch's junk-bond index is 5.45 percentage points above Treasuries vs. the 4.25 historical average. ''Even if you don't see a lot of capital appreciation in high yield, and all you do is earn the coupon, you can still do as well as you'll probably do in equities,'' says Margaret Patel, portfolio manager of the Third Avenue High-Yield Fund. The safest plays in the junkyard can be found in the telecommunications industry, which, given the explosive growth of the Internet and other digital services, is expected to continue expanding regardless of what happens to the broader economy. Bender's co-manager at Strong, Jeffrey Koch, favors Nextlink Communications, Metromedia Fiber Network, and Global Crossing. Global, for example, was yielding 9.4% in mid-December. LEVERAGED. Many of the bond mavens surveyed were relatively cool to asset-backed securities, particularly mortgages, given the relatively low yields and ongoing prepayment risks as homeowners refinance. Among other plays, Millhouse likes the debt of several real estate investment trusts, including Equity Office Properties Trust and Dominion Real Estate. ''REITs are much less leveraged than they were in the 1980s,'' he says. If the pros are cool on asset-backed securities, they're downright cold on foreign markets. With most European short-term rates already below 4%, experts see little room for further gains. The exception is Britain, where Sykes Wilford, managing director for CDC Investment Management Corp., a New York hedge fund, believes that ''the British gilt is one of the best plays out there.'' The experts also recommend steering clear of emerging markets such as Thailand, Venezuela, and Korea, which they believe are overpriced even at today's enticing yields given the potential for further currency shocks. ''The yield spreads in many emerging markets,'' says Patel, ''still don't reflect the fact that these countries have genuine economic problems and are going to be in recession for some time.'' If you do dabble in emerging markets, be sure to diversify. In recent years, investors often profited nicely by stepping in and buying during the dips and downturns. But the easy money is behind. From now on, bigger returns won't come without bigger risks.
By Dean Foust in Atlanta RELATED ITEMS
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Updated Dec. 17, 1998 by bwwebmaster
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