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`There Are No Screaming Buys'


Cover Story -- Bonds

`THERE ARE NO SCREAMING BUYS'

Spreads between Treasuries and other bonds are narrowing, leaving investors slim pickings

For bond fans, it looks like hard work ahead. Many economists see a friendly economic and interest-rate outlook. There's little fear of those nasty, principal-eroding interest-rate spikes. Trouble is, the supply of new government securities is shrinking and interest-rate spreads between Treasuries and other issues are narrowing, with the result, experts say, that bonds are generally fairly valued. The bottom line: The bond market for the time being will be attractive mainly to people who like a good challenge.

The difficulties in dealing with the market stem mainly from the benign economy. Typical of the believers in a rosy scenario is David M. Jones, chief economist at Aubrey Lanston & Co., a government securities firm, who projects "solid and well-balanced growth" with mild inflation. By fall, he thinks that the Federal Reserve might nudge up short-term rates in a couple of quarter-point increments. And he is always on the lookout for some unforeseen shock. "The thing to keep your eye on is wage-price pressures," he says. But he doesn't expect the benchmark 30-year Treasury to exceed 7.25% this year. Indeed, Jones thinks it could drop to 6.5% in 1998 as the economy slows.

AGING YUPPIES. "There are no screaming buys," laments Leslie Nanberg, fixed-income chief at Massachusetts Financial Services (MFS). Investors are facing what Merrill Lynch & Co. chief investment strategist Charles I. Clough Jr. calls a "shortage of yield" resulting from both the shrinkage in supply of new securities and an increase in demand. One reason is that the federal government is now paying more in interest than it borrows, he explains. Moreover, aging yuppies are paying off their mortgages faster than they are signing up for new ones. The predicament is similar in the municipal-bond market, where a drop in refinancings and capital expenditures by states and municipalities has slashed new issuance since the early 1990s.

All of which has spurred bond investors to explore less obvious sources of above-average yields. Clough points out that "the emerging-debt market is strong and high-yield spreads are the lowest they've ever been." But he warns investors against falling for exotic and seemingly high-yielding issues--such as Hungarian bonds--that don't fully reward buyers for their risks. Right now, Clough favors U.S. Treasuries, especially liquid 20-year zero coupons with yields to maturity of 7.12%. Loomis, Sayles & Co. Executive Vice-President Daniel J. Fuss--who thinks that the "principal risk is lower rates, not higher"--suggests building a maturity ladder of 5-, 10-, and 28-year Treasuries.

For conservative investors looking for more juice than Treasuries but less risk than junk bonds, experts suggest par value Government National Mortgage Assn.-backed securities, which are yielding about one percentage point more than Treasuries but are fully backed by the U.S. government. With rates likely to remain fairly stable, prepayment risk appears minimal.

TOP TIER. Until recently, there were munis aplenty to suit every investor's taste. No longer. So far this year, new issuance is running at an annual rate of about $170 billion, down from the historic peak of around $292 billion in 1993. That means investors will have increasing difficulty finding issues that satisfy their exact maturity, tax, and yield requirements. Moreover, the ratio of the yield on triple-A long-term munis to 30-year Treasury yields fell in May to about 79%, down from 90%-plus last year.

Although there are few compelling buys, Thomas J. Kenny, director of munis at the Franklin Templeton Group, argues "they should still outperform other options." James J. Cooner, senior vice-president for tax-exempt bonds at Bank of New York, advises looking for issues with seven-year maturities. In high-tax states such as New York and New Jersey, the 5% tax-free yield is equivalent to a taxable yield of about 10% for individuals in top tax brackets. Accordingly, Garrison (N.Y.) financial adviser Byron S. Stinson is recommending New York City general obligations to clients, betting that Big Apple paper, now rated triple B and yielding about 6%, will eventually be upgraded because of the city's improving financial health.

Cheap junk is virtually impossible to find--average spreads have declined to about 315 basis points over Treasuries, from around 350 basis points last year--but some bond gurus think the market is still appealing. One reason, says MFS's Nanberg, is that corporate-credit quality keeps getting better. Although he generally favors near-investment-grade issues, he makes an exception for certain single-B-rated issues such as Cablevision Systems Corp., which enjoys a dominant share of the New York area cable-TV market. But Mark A. Jablonski, managing director of Performance Trading Technologies, a trading firm that uses a proprietary software forecasting program, expects spreads on junk issues (and on emerging-markets issues) to widen as the Fed tightens. "Investors should become more defensive. Those with higher-risk corporates should move into investment grades and shorten maturities," he advises.

A bright spot in this field of fairly slim pickings is real estate investment trusts, which feature quite attractive yields (page 124). Merrill Lynch REIT analyst Eric Hemel, for one, thinks the good ones will continue to deliver long-term total returns of 12% or more.

DOWN-UNDER DIP. On the international front, things have tightened up as well. Unlike last year, there are few if any slam-dunk capital-gains plays. Loomis Sayles's Fuss still likes bonds issued by Canada's Western provinces. Except for Irish governments, which he thinks are fairly valued, he would avoid Europe entirely. MFS's Nanberg thinks buyers of Australian 10-year bonds, now yielding about 7.45%, could pick up some gains if, as he expects, Down Under rates drift down.

As for emerging-markets bonds, which in 1996 outperformed every sector, equities included, prices are also firming. Still, the J.P. Emerging Market Brady Index is up 4.8% through April, and many strategists think these issues will continue to do well. One reason, says Nanberg, is the unflagging commitment by financial authorities in countries such as Argentina to tame the inflation beast.

Buyers of emerging-markets debt could also benefit from expected upgrades in countries such as Peru and Venezuela. One caveat: That's exactly what some fixed-income gurus predicted for Mexico just weeks before its December, 1994, currency crisis. Still, Scott E. Pardee, senior adviser at Yamaichi International (America) Inc., thinks spreads over Treasuries of Mexican, Brazilian, and Argentine bonds could fall an additional 25 basis points. For investors with cast-iron stomachs, some experts think Thailand, South Africa, and Russia are worth checking out. Thailand, says Fuss, has been clobbered so badly that Euroconvertible issues of major Thai companies are very cheap--albeit very risky. In South Africa, rand-denominated government paper is yielding around 15%. And Russian short-term Treasury bills currently yield about 11%. But most experts warn ordinary investors against buying single issues of these securities.

In short, there are good values out there. But finding them won't be a piece of cake.By Phillip L. Zweig in New YorkReturn to top


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