Bonds: Sorting Through the Confusion

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Michael Pond, fixed-income strategist for inflation-linked assets at Barclays Capital (BCS), also expects inflation to decelerate this year, but he says TIPS will continue to offer more value than other government bonds that aren't adjusted for inflation. He says five- and 10-year TIPS are fairly valued, while one-year TIPS are undervalued. The market is pricing in a 0.8% rise in consumer prices in 2010, vs. Barclays' forecast for a 1.7% increase and a 1.1% gain in the core inflation rate, which doesn't include food and energy price hikes.

Withdrawing Stimulus in Time

"If inflation is rising at a slower pace this year, but investors are becoming more concerned about inflation over the medium term, TIPS can still do very well relative to nominal Treasuries," says Pond. He doesn't expect anything close, however, to the 16% outperformance that Barclays TIPS index delivered in 2009 compared with a basket of similar unlinked bonds.

By pricing 10-year TIPS at 2.40%, just below the baseline inflation rate of 2.5% expected over the coming 10 years, the market is saying it expects the Fed to get its timing right and withdraw the fiscal and monetary stimulus before they stoke inflation, Pond says. But he argues that markets need to be priced for potential risks, not just for baseline expectations. In his view, the risks include not just the possibility that the Fed will wait too long to withdraw the stimulus, but signs of increased pricing power in certain industries, such as air travel and rising food and energy costs.

One reason inflation forecasts may vary so much is the different weights that economists and Wall Street pros give to such contributing factors as wages and commodity prices. Barry Bosworth, senior fellow at the Brookings Institution in Washington, focuses on the fact that wages now account for roughly 70% of growth in national income.

Little or No Wage Inflation

"Unemployment looks like it will stay extraordinarily high for several years. It's hard to imagine workers bidding up their wages" as long as there's so much excess capacity in the labor market, he says. "I'm looking for a slowing of wage inflation. That's what I consider to be the core measure of inflation."

He thinks it's possible that other countries' economies will recovers faster than the America's, which could mean higher commodity prices, "but they're a relatively small part of the inflation picture," Bosworth adds.

Joy at RiverSource is warning clients that most of the total return in their fixed-income portfolios this year will come from the coupon interest on the bonds they own. That's not nearly as compelling as last year, when investors not only earned coupon income but gained from extraordinarily strong price appreciation as interest rates came down and credit spreads contracted.

Doug Roberts, chief investment strategist at Channel Capital Research in Shrewsbury, N.J., believes high inflation would occur only if an international military conflict disrupts supply of a key resource such as Middle Eastern oil.

A Surge in Protectionism

Bosworth at Brookings thinks economic conflicts over trade deficits, which could spark a new wave of protectionism, are a bigger risk than military conflicts. But that would lead to deflation, not inflation, because the unavailability of certain resources would hamper economic expansion.

He expects the backlash against free trade "to worsen next year when the American public realizes we're not going to get back to normal employment anytime soon and they start looking around for someone to blame and turn to China [to blame] because of the trade deficit." The fact that China doesn't seem committed to lowering its current account surplus with the U.S. and other countries exacerbates the problem, he says.

Although Joy doesn't see significant inflation for the next one to two years, he believes investors need to be encouraged to have some exposure to TIPS to be ready for inflation when it comes.

The Appeal of Emerging Markets

He sees opportunity for higher returns in corporate bonds in the more robust emerging markets, where credit spreads have contracted substantially but there's still room for further contraction. He points to Brazil, where fiscal management has been solid and inflation has been declining, which should allow for lower interest rates. Investors should be more careful in other emerging economies, such as Eastern Europe and the Baltic states, where there's been excessive borrowing.

There may also be more opportunity, Joy says, in BBB-rated bonds and B- and BB-rated bonds in the high-yield corporate bond market, where credit spreads remain higher than their historical averages and could narrow further if the economy continues to improve.

"One wild card in all of this is if the Fed slows down or stops its purchases [of Treasury bonds] in the secondary market," he says. "We could see yields begin to rise in some longer maturity parts of the high-grade fixed income market."

The extent to which bond yields may rise once the Fed removes quantitative easing measures is one of the key things to watch in 2010, according to Citi's Dec. 14 outlook report. Citi expects a 15.3% increase in the supply of Treasury bonds this year and predicts the yield on the 10-year Treasury bond will climb about 0.9%, to 4.45%, in the fourth quarter of this year as a result.

But it's important that investors not misread a rise in interest rates due to diminished demand for Treasuries—as the Fed begins to exit its extraordinary stimulus programs—as a sign of increasing inflation, says Joy. That's one of many sources of confusion investors can expect when it comes to the bond market outlook in 2010.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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