2/17/2012 2:31 PM ET|
Where to get the best bond yields
The news that the Fed intends to keep interest rates low should extend the bond rally, but ETF investors will want to steer clear of broad-market funds.
The long-running bull market in bonds should continue this year, albeit with different sectors leading the way.
Treasury bonds continue to defy bubble predictions, and the Federal Reserve's late January announcement that it is likely to keep rates low at least until late 2014 could extend the Treasury rally a tad longer, says Scott Kimball, a portfolio manager with Taplin, Canida & Habacht.
The Fed acknowledged in its recent statement that inflation remains subdued and that it expects only modest economic growth, affirming an easy-money policy for the foreseeable future.
Analysts expect the policy to prod investors into riskier assets and act as a form of insurance against continued instability in Europe.
So, with 10-year nominal yields hovering around 2% and real yields negative when adjusted for inflation, the desire for higher income should trump safety and lead bond investors into the sectors that offer yields that exceed what's now available via Treasurys.
Combine a desire for yield with expectations for slow but steady economic growth and tame inflation, and you have an environment that should benefit all but the priciest U.S. bonds.
For exchange-traded fund investors, this means avoiding the government-heavy broad-market vehicles like iShares Barclays Aggregate Bond (AGG)and Vanguard Total Bond Market (BND), and drilling down to the spread sectors.
"We're very constructive on corporate credit; the fundamentals look extremely positive,'' says Chris Molumphy, Franklin Templeton's chief investment officer of fixed income.
U.S. corporate bonds turned in a solid 8.1% performance in 2011, and the momentum has remained. Companies have increased profits through a sluggish recovery by cutting debt, boosting productivity and taking advantage of ultralow interest rates to refinance at favorable terms. These actions have helped improve credit quality, one of the main drivers of price increases.
Improving fundamentals and a stabilizing economy should also benefit junk bonds. The prevailing default rate of 1.7% for bonds rated below investment grade is low compared with the 4.2% long-term average.
Junk-bond issuers should be in the clear for the next three years, before the effects of refinancing at lower rates and extending maturities begin to wear off, says Mary Austin, the portfolio manager of the Pax World High Yield Bond (PAXHX)fund.
"When GDP (growth) is 2% or lower, high yield has historically outperformed,'' Austin adds.
Bonds backed by mortgages underwritten by Fannie Mae, Freddie Mac and Ginnie Mae should also do well in a low-growth environment. These bonds, most of which carry an implicit government guarantee, offer yields double those of similar-maturity Treasurys.
Continued government efforts to revive the housing market should limit the number of mortgages that fall into delinquency and keep principal and interest payments flowing to bondholders. The possible Fed purchase of mortgage-backed securities as part of another round of quantitative easing is also a positive, says Kimball.
Molumphy places emerging-markets bonds at the top of his list, citing yields that are higher, economic growth rates that are faster and debt levels that are lower than comparable levels in the struggling economies of Europe and Japan.
Emerging-markets bonds suffered from price declines and a foreign currency sell-off in 2011 as investors spurned risky assets. This action leaves them attractively valued, with their economic advantages still in place.
"Investors have yet to price in the strong fundamentals of the developing markets,'' says Buff Dormeier of Wells Fargo Advisors.
Investors can own emerging-markets bonds denominated in U.S. dollars or play the expected strengthening of emerging-markets currencies against the dollar through bonds denominated in local currencies.
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