If you are a bond investor, beware of letting the stock market make you feel comfy.
The stock market has been reaching new highs, but bond analysts are warning that stock prices do not reflect the potential risks ahead for the economy or high-yield bonds.
Stocks are being driven higher by conditions good for stockholders, but not necessarily for the economy or corporate bonds. Flush with cash, companies are buying back shares of their stock, paying dividends and conducting huge mergers and acquisitions.
That is not spending that goes back into the economy, said Merrill Lynch economist David Rosenberg. And orders of capital equipment--which do fuel economic expansion--are slowing.
Given that backdrop, bond analysts have been warning clients during the last few days that this is no time to try to give a jolt to bond portfolios by taking a chance on high-yield bonds.
"Although investor risk appetite looks elevated at present, the growth slowdown under way is not seen as supportive for the high-yield market," said Standard & Poor's managing director Diane Vazza in a recent report. "We perceive risks ahead and continue to question excessive investor complacency."
Likewise, Merrill Lynch bond strategist Martin Mauro has cautioned: "We think that investors should prepare for further slowing in the economy and Federal Reserve rate cuts next year."
"We recommend that investors avoid reaching for yield through either moving down in quality or staying in short-term maturities," he said.
Goldman Sachs bond strategists also are wary. "Market sentiment feels a little overheated, especially given the relatively weak signals we've been getting on the macroeconomy," Goldman said in a report. While investors are probably feeling confident because there have been so few bond defaults, Goldman analysts are expecting the bullish attitude "to lose steam as defaults rise in the second half" of 2007.
Besides steering clear of high-yield bonds, analysts say the easy strategies of the last couple of years are less attractive now. Investors have been able to park money in money-market funds and earn about 5 percent. But if the economy slows, and interest rates go down next year, money-market funds and bonds that mature in a couple of years won't pay as well as they have.
Marie Schofield, senior portfolio strategist for Columbia Management, suggests that investors branch out if they have been relying on money-market funds and bonds or CDs that mature in a couple of years. She suggests putting some money in Treasuries, CDs or high-quality corporate bonds that mature in three to five years.
That might seem silly on the face of it because those investments currently are yielding somewhat less than shorter-term bonds. For example, Treasury bonds that mature in two years recently were yielding 4.58 percent, while 5-year bonds were yielding 4.44 percent.
But Schofield notes that in 2003, while the economy was weak and investors were risk averse, 10-year Treasury bonds were yielding only about 3 percent. "So 4.5 percent is not too bad right now," she said.
To pick up a little more yield, Schofield says investors could choose high-quality corporate bonds for companies rated A or AA. But she says they only yield about a third of a percentage point more than Treasuries. And investors must be cautious about corporate bonds in the current environment.
Given the active leveraged-buyout market, she said, even speculation that a company could be a target for a leveraged buyout may cause bond values to plunge.
In the buyouts, strong companies with solid financial records can become loaded down with debt from acquirers, and old bonds can suffer.
Mauro said that for people in the 28 percent federal tax bracket or higher, intermediate- or long-term municipal bonds offer better yields than after-tax Treasuries. But he urges investors to diversify in multiple geographic areas, so they won't be highly exposed if one area's economy suffers more than another.
Because he expects the Federal Reserve to cut interest rates aggressively next year, and long-term yields to decline, he also suggests zero-coupon bonds. The prices will rise if rates fall.
Meanwhile, Jack Ablin, chief investment officer of Harris Private Bank, is having retired investors hold a combination of convertible bonds, high-dividend-yielding stocks such as utilities, international bonds and U.S. real estate to generate income.
"During the last 25 years, we enjoyed the best conditions we could for bonds," he said. "Ten-year Treasuries earned a 10 percent total return per year. What's the chance that will happen the next 25 years? ... Zero!"
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