Some Are Looking Beyond Treasuries

The sharp rebound in Treasury yields in the last week and a half gives investors who have been waiting to buy bonds a chance to lock in much higher returns.

But some portfolio managers and investment advisors think there may be better opportunities than Treasuries for income-oriented investors.

“Those who missed the [Treasury bond market] rally of the last 18 months have missed out,” said Paul McCulley, portfolio manager at Pacific Investment Management Co. in Newport Beach, which runs the Pimco bond funds. The recent jump in yields means “those who want their money in a safe haven may get a better deal than they did a week ago, but this isn’t the buying opportunity of a lifetime at all.”

Yields on some Treasury issues plunged to their lowest levels in 40 years after the government’s surprise announcement in late October that 30-year bonds no longer would be issued. But since bottoming out Nov. 7, rates have roared back.

The yield on the benchmark 10-year T-note, for instance, has soared from 4.18% on Nov. 7 to 4.85% as of Friday. That left it at the highest level since the Sept. 11 terrorist attacks.

The yield on five-year T-notes was 4.23% as of Friday, up from 3.47% on Nov. 7.

Buyers had poured into ultra-safe Treasuries after Sept. 11. But now that investors appear to be warming up to the idea of an economic recovery in 2002, money has been flowing out of bonds and into other investments--including stocks. Since its post-attacks low Sept. 21, the Standard & Poor’s 500 index of blue-chip stocks has surged nearly 18%.

Along with rising optimism for the economy next year, progress in the Afghanistan conflict has played a big role in whetting investors’ appetites for more risk and reward, money managers say.

“There is a perception that the war on terrorism is being effectively prosecuted and that life is going to return to something like before Sept. 11,” said Tad Rivelle, portfolio manager at Metropolitan West Asset Management in Los Angeles.

Rising Treasury yields can benefit investors who put off asset-allocation moves this year and missed out on the bond rally. If, for the long haul, your portfolio needs more bonds and fewer stocks, rebounding market yields are your friend, experts say.

But McCulley said fixed-income investors need to temper their expectations, especially if they need the safety that Treasuries provide.

“Be content with mid-single-digit returns,” McCulley said. “The double-digit returns of the past two years are gone,” he said, referring to bonds’ “total returns,” meaning interest income plus price appreciation. “You don’t get to go to heaven twice for the same recession.”

Anticipating an economic recovery in 2002, he thinks income-oriented investors probably will do better owning high-quality corporate, Ginnie Mae mortgage and municipal bonds and bond mutual funds.

“Treasuries are going to be the ugly duckling over the next year,” McCulley said.

John Hakopian, portfolio manager at the Keller Group, an investment advisory firm in Irvine, said high-quality corporate bonds and mortgage-backed securities sell at generous yields compared with Treasuries of similar term, relative to historical norms.

Mortgage-backed bonds, for example, typically yield 150 to 160 basis points, or 1.5 to 1.6 percentage points, more than Treasuries. But that “spread” is now more than 2 percentage points in many cases. On high-quality corporate bonds, the average yield advantage over Treasuries is about 150 basis points, compared with a more normal 80 to 100 basis points, Hakopian said.

Likewise, Rivelle cautions fixed-income investors against playing it too safe with Treasuries, saying this isn’t the time “for hunkering down and avoiding credit risk at all cost. The time to do that was probably a year ago, because the economy appears to be on its way to recovery at this point.”

He said investors expecting an economic upturn next year might want to consider buying a high-yield “junk” bond fund, as well as stocks and investment-grade corporate bonds.

Investors who have been waiting to buy corporate junk bonds will find yields lower now than a few weeks ago--the opposite of what has happened with Treasuries. Expectations of an economic rebound in 2002 have bolstered investors’ confidence in riskier companies, so they’ve been more willing to buy junk issues.

AMG Data Services, which estimates cash inflows and outflows of mutual funds, said junk bond funds took in $816 million in new money in the week ended last Wednesday, the biggest inflow since January.

The yield on an index of 100 junk bonds tracked by KDP Investment Advisors fell to 10.89% by late last week. It had been 12.1% in late September.

Still, risks remain high that more junk bond issuers will default because of the weak economy, analysts say.

For cautious investors, Treasury securities have several selling points. Along with being ultra-safe, they are highly liquid, which is important to active traders or those who might suddenly need cash. Also, interest paid on Treasuries is exempt from state income tax.

Some strategists are still unabashedly bullish on the Treasury market. “If you’re buying for rate of return, I would allocate something to 10-year or even longer-term Treasuries. I think the stock market has gotten ahead of itself,” said David Horner, senior financial strategist at Merrill Lynch. “I don’t think corporate earnings support these stock valuations,” which means that money eventually may shift back to bonds from stocks, he said.

For investors who believe in an economic recovery in 2002, Horner thinks investment-grade corporate bonds may be a good way to play it, thanks to their higher yields.

“But if you think the economy is in trouble, you might want to stick with Treasuries,” he added.

Horner said it may be six months before evidence of an economic upswing is clear enough for interest rates to start heading broadly higher again.

Hakopian said that although he thinks yields on corporate and other bonds make a little risk worth taking, highly risk-averse investors could do worse than buying Treasuries now.

“I think the economy is going to bounce back, but gradually, so I don’t expect interest rates to rise significantly,” he said. “The 8% days of high-quality fixed-income are long gone.”

If inflation remains low, analysts say even a 4.85% annual yield on a 10-year T-note could be an attractive risk-free return--especially if the stock market’s returns average out to single digits in the next decade.

For investors concerned about taxes, municipal bonds appear to provide good value, said Kurt Brouwer, an investment advisor in Tiburon, Calif. Bonds issued by California or its municipalities are exempt from federal taxes and from state taxes for California residents.

As with Treasuries, muni yields rebounded sharply last week, so returns may be much more attractive for new buyers.

With any kind of bond, there are pros and cons of individual securities compared with bond mutual funds.

For instance, the yield of an individual Treasury bond is locked in, and the buyer is guaranteed to get the bond’s face value back at maturity.

With a bond fund, by contrast, the yield will fluctuate as the underlying portfolio changes. There is no guarantee that the investor’s principal will stay level or appreciate: If market rates continued to rise, bond fund share values will decline as older fixed-rate bonds decline in value.

But bond funds offer convenience and the ability to quickly redeem part of an investment if necessary.