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If Rates Are Up, Why Are Bonds?


It's not supposed to happen this way. The Federal Reserve is hiking short-term interest rates, yet yield-oriented investments are thriving. In the third quarter (through Sept. 17), the total return of the average bond fund rose 2.74%, real estate funds gained 7.95%, and funds that specialize in utility stocks jumped 5.53%. Even funds holding financial stocks were up 2.83%. The gains caught many savvy mutual fund managers off-guard. "We really thought we'd see some pressure on bonds by now," says Robert Ostrowski, an 18-year veteran of the bond market who oversees $24 billion in fixed-income assets at Federated Investors.

Go figure. Equity funds should have done better. After all, the Fed doesn't raise interest rates in a weak economy. Yet diversfied U.S. equity funds were down, on average, 2.5% -- a showing worse than the Standard & Poor's 500-stock index's 0.8% loss. Large-capitalization value funds fared best, up 0.45%. Funds investing in growth stocks took a drubbing. And despite a late-in-the-quarter rally, technology funds declined nearly 11%. Fund data are calculated by Standard & Poor's, which, like BusinessWeek, is a part of The McGraw-Hill Companies (MHP).

What's behind the strength in bonds? Some pros say hedge funds, using lots of borrowed money, are buying in quantities large enough to push prices higher and yields lower. "I haven't seen this kind of leveraged money in fixed-income since 1993-94," says Joe Deane, managing director of Citigroup Asset Management (C), who runs about $7 billion in various fixed-income funds. That was a volatile period for the bond market -- and not a good time for stocks, either. Deane predicts that bonds will be "extremely volatile" for the next two years. "It's a great time to be cautious," he adds.

REAL ESTATE SAVVY

Some would say the same about real estate funds. After all, prices for land and properties remain strong in the face of higher rates. But Darren Rabenou, a member of the real estate team at J.P. Morgan Fleming Asset Management who oversees the $160 million Undiscovered Managers REIT Institutional (URTLX) fund, isn't concerned. "[Real estate investment trusts] are enjoying the best of all worlds," says Rabenou, whose fund gained 8.1% in the quarter. The stock market can't get any traction, nor can bonds deliver much yield. Meanwhile, the real estate industry's fundamentals are improving. Occupancy rates are rising in the office and apartment sectors, and earnings industrywide are picking up. To that end, Rabenou favors investments such as ProLogis Trust (PLD), an operator of distribution centers and warehouses, which is poised to benefit from an improving economy as companies stockpile more equipment, materials, and consumer goods.

Another strengthening corner of real estate is lodging. Ted Bigman, manager of the $1 billion Morgan Stanley Real Estate Fund, which is up 9.32% for the quarter, likes Starwood Hotels & Resorts (HOT). The White Plains (N.Y.) company is concentrated in major urban markets, with brands such as Sheraton, St. Regis, and W that cater to business travelers. Although companies haven't ramped up hiring, "business travelers have the green light again to go out and travel," Bigman says. Better exposure to the New York market, he says, separates Starwood from its competitors.

SHYING AWAY FROM SMALL-CAPS

The economic expansion should give a lift to U.S. diversified funds, too, especially those that focus on big blue-chip names. "The underlying business backbone of Corporate America is getting stronger every day," says Robert Zagunis, co-manager of the $2.4 billion Jensen (JENSX) fund. He's favoring megacap companies such as General Electric (GE) and pharmaceutical giant Pfizer (PFE).

Although large-capitalization growth funds declined by nearly 4% during the quarter, Zagunis is unfazed. After all, he knows a thing or two about the potential of an underdog: He's a former U.S. Olympic rower whose daughter Mariel won a gold medal in fencing at this summer's Olympics in Athens after nabbing a slot on the U.S. team at the last minute.

If fund managers are bullish on big caps now, they're shying away from small-company stocks, which outperformed the broader market over the past few years. James Margard, lead manager for the $380 million Rainier Small/Mid Cap Equity Fund (RIMSX), is shifting his focus to midsize companies ($2 billion to $12 billion market caps) because that's where he is finding better deals with a lot less risk. One of the fund's largest holdings is Joy Global (JOYG), a Milwaukee producer of mining equipment. Components account for two-thirds of sales at Joy Global. "There's a continuous flow of orders to replace worn-out parts," Margard says. Some 70% of Joy Global's business is linked to coal mining, and increased demand in China is driving much of those sales.

Beyond the U.S., more risky emerging-market bonds, as well as Latin American stock funds, fared well during the quarter, rising 8.85% and 12.81%, respectively. Issuers of emerging-market debt and equities can thank fundamental economic changes in the past few years for the enhanced performance. Better balance sheets are luring David Antonelli, director of global equity research at Massachusetts Financial Services, and other investors to nations south of the border, where countries have restructured their debt to more manageable levels.

Antonelli favors Mexico because of its close trade ties to the U.S. He sees improved performance for media operator Grupo Televisa (TV), which dominates in Mexican broadcasting and is poised to benefit as advertisers spend more money. Antonelli, who manages the $1.6 billion MFS International New Discovery Fund, also is putting money to work in small and midsize Japanese companies. During that country's prolonged downturn over the past decade, companies cut costs sharply to stay afloat. Now that Asian markets are growing rapidly, demand is high, and "companies have tremendous leverage on the bottom line," he says.

One example is Japan's Seiko Epson, a maker of electronic devices as well as printers, with net sales of 1.4 trillion yen ($12.7 billion), which restructured and trimmed costs across its diverse business lines. "It's the classic blade-and-razor story," says Antonelli. "As sales of printers pick up, you make all the money on supplies and toners." He predicts that the company will see double-digit earnings growth during the next two years. Double-digit earnings for a Japanese company? Maybe this time, Japan's rebound is for real.

By Lauren Young


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