from Barrons: Bonds are Back

Monday, April 21, 2008


FEATURES MAIN




Bonds Are Back in the Game
By ANDREW BARY

FOR THE FIRST TIME SINCE THE credit scare of 2002, most taxable bonds offer a compelling alternative to stocks.

With the stock market's rebound tentative at best, and money-market mutual funds paying just 2%, down from 5% a year ago, that's good news for yield-hungry individual investors. Junk bonds, convertible securities and mortgage-backed debt provide attractive yields with varying amounts of appreciation potential, and all fit particularly well in tax-deferred accounts like IRAs.


High-yield, or junk, debt, now yielding an average of more than 10%, could generate 15%-plus returns in the next 12 months if the economy bottoms later in 2008, while equity-sensitive convertibles could rise 20% or more. The convertible market has seen heavy new issuance lately as financial companies, including Citigroup (ticker: C), Bank of America (BAC) and Wachovia (WB), have sought to bolster their depleted capital by selling billions of dollars of convertible-preferred stock. These NYSE-listed issues are yielding 6% to 7%, some of them more than the common shares.

Mortgage securities issued by the three government-sponsored agencies, Ginnie Mae, Freddie Mac (FRE) and Fannie Mae (FNM), now yield about 5.5%, and could show high single-digit returns in the next year. Depressed non-agency securities backed by prime and so-called Alt-A loans could produce mid-teens returns.

The safest market is the most unappealing: U.S. Treasuries. With Treasury yields ranging from 2.2% on a two-year note to 4.6% on a 30-year bond, investors are getting negative real yields after taxes and inflation, now running at 4%. Given low Treasury yields, its possible total returns (yield plus bond-price change) could be negative in the next year.




Junky No More: Junk bonds now yield nearly eight percentage points above Treasuries, while investment-grade bonds yield three points more.
Barron's Roundtable member Bill Gross recently called Treasuries "the most overvalued asset in the world, bar none." In a CNBC interview, Gross, who manages the country's largest bond fund, Pimco Total Return1 (PTTRX), added that Treasury yields "don't make any sense relative to inflationary expectations down the road." Pimco Total Return has been tilting away from Treasuries and into mortgage securities, which Gross says "represent some of the most compelling values" in the bond market.

Larry Fink, the chief executive of BlackRock, a big bond manager, said on the company's earnings conference call last week that he has been telling clients "it is time to take more risk, and...start looking to move away from Treasury-oriented strategies to more credit-oriented and mortgage-oriented strategies."

Municipal bonds look appealing relative to Treasuries, but their absolute yields aren't great. The muni market has rallied in the past month with yields on top-rated long-term issues now in the 4.5% to 4.75% range, down from a peak of 5.5% or more. Munis yield more than Treasuries, which is rare because of the tax benefits of munis, but Treasury yields are extremely low. A five-year muni yielding 3.25% might look good relative to a Treasury at 3%, but even a tax-free 3.25% yield doesn't look great relative to inflation.

THERE ARE MANY WAYS TO INVEST in the bond market, including individual debt issues, open-ended mutual funds, closed-end funds and, more recently, exchange-traded funds. In the tables on the next page, we've listed a range of attractive bond-investment choices, including mutual funds and individual convertible and junk issues. Mutual funds are a particularly good idea for mortgage securities, given the hassle of trading individual mortgage issues and the difficulty of reinvesting periodic principal payments.

The direction of the U.S. economy, the global financial backdrop and the health of the housing market will be critical to bond returns over the next year. Treasuries and, to a lesser extent, munis would be helped by a weak economy, while most other sectors would be hurt.

Here's a closer look at the individual market sectors:

Junk

Many junk-bond mavens agree the market looks enticing, with the average issue yielding 10.5%, and bonds from distressed concerns like Charter Communications, Tribune and Realogy yielding more than 20%. The issue is timing. Some investors think the market will get worse before it gets better, particularly if the economy sputters for the rest of '08 and defaults spike, as expected.

"This is about the only cycle when spreads have widened so much before a rise in defaults," says Marty Fridson, chief executive of FridsonVision, in New York.


"It might be a little early. Our sense is that the economy will remain weak for the next three to six months and corporate earnings will be ugly," says Mark Vaselkiv, manager of the T. Rowe Price High-Yield Fund2 (PRHYX). Vaselkiv says the high-yield spread above Treasuries, now about 7.75 percentage points, could top 8 percentage points again later this year. The spread hit 8.5 points in March and was as wide as 10 points in 2002. Last spring, it stood at just 2.5 points.

While the $1 trillion junk market could hit another rough patch later this year, Vaselkiv finds plenty of bonds to buy, including those of General Motors Acceptance Corp., Sprint and Harrah's Entertainment. GMAC has been hurt by losses at its mortgage unit, but its core auto-finance business still is reasonably healthy.

"Senior management continues to emphasize it will capitalize GMAC appropriately, and there's no way GM survives without GMAC," Vaselkiv says. GMAC's one-year debt now yields 11%, while long-term issues, like the NYSE-listed 7.25% bond due in 2033 (ticker: GKM), yields 11.50%. This issue has a face value of $25 and trades around 16, or about 64 cents on the dollar. Most corporate bonds are sold with a face value of $1,000.

SPRINT APPEALS TO VASELKIV because its debt yields about 9.5%, yet it still has investment-grade credit ratings. Sprint's profits have disappointed and the company has been losing market share. Wall Street worries about Sprint's $22 billion of debt, but the company's ratio of debt to annual cash flow is around 3, versus a ratio of 10 for heavily leveraged companies. And, Sprint (S) still has a stock-market value of $20 billion.

Berkshire Hathaway CEO Warren Buffett also has been attracted to the junk market, buying debt issued by TXU, the Texas utility that was subject of an $43 billion leveraged buyout last year. TXU bonds, like the 10.25% issue due 2015, yield a shade under 10%. It's a good bet Berkshire bought more junk in the first quarter.

Harrah's went private in a $27 billion LBO earlier this year, just as the supposedly recession-proof casino industry hit a downturn. Reflecting concerns about Harrah's debt load, the company's senior unsecured bonds, like the 10.75% bonds due in 2016, trade for 84 cents on the dollar and yield 14%. The junior debt yields as much as 20%.




While junk funds generally have had negative returns in the low single digits in the past year, the situation could change in the next 12 months given high yields and depressed prices throughout the market.

The yield gap of high-grade bonds relative to U.S. Treasuries also has gotten wide, hitting 3 percentage points in late March, compared with less than a point a year ago, according to Merrill Lynch.

Reflecting this trend, GE Capital, which has a triple-A credit rating, last week issued 10-year debt at 5.66% and 30-year bonds at 6.45%, both about two points more than Treasuries. Intermediate-term debt from the major brokers yields 5% to 6%. With the Federal Reserve essentially throwing a safety net under the brokerage industry, it's unlikely companies like Lehman Brothers (LEH), Merrill Lynch (MER) and Morgan Stanley (MS) will default on their bonds.

Convertible Bonds

Convertibles combine two attributes: bond yields and the appreciation potential of stocks. Investors eyeing the depressed financial sector have plenty of convertible choices because Citigroup, Lehman Brothers, Bank of America, Wachovia, Washington Mutual (WM), MGIC (MTG) and SLM (SLM) all have tapped the market this year. "Boomlets in issuance often coincide with a sector that has gotten cheap," says David King, manager of the Putnam Convertible Income Growth Fund3 (PCONX) and the closed-end Putnam High-Income Securities Fund (PCF). King, a long-time convertible investor, has bought the Citigroup, Bank of America, Wachovia and Lehman issues.

The new convertible preferred issues generally yield 6% to 7%, offer more secure dividends than common shares, and, quite important, give investors plenty of time to benefit from stock appreciation thanks to five years of call protection. Some converts, like the Citigroup issue, were sold originally at $50 a share, while others, like the Bank of America and Wachovia deals, have a face value of $1,000.

Financial companies also have been issuing tens of billions of dollars of fixed-rate nonconvertible preferred stock this year. The converts probably are a better deal, as the straight preferred issues yield around 8% but have limited upside potential. It's a different story with converts. If the underlying stocks gain 25% over the next year, converts could rally 10% to 15%, producing total returns of around 20%.




The Fidelity Convertible Securities Fund4 (FCVSX) has increased its exposure to financials lately from a near-zero weighting. The fund, managed by Tom Soviero, has scored with investments in commodities and energy, including Freeport McMoRan Copper and Gold (FCX). It's up 15% a year in the past three years, almost double the average return on convert funds.

General Motors (GM) and Ford Motor (F) converts are excellent alternatives to the companies' common shares because they're debt, not preferred, and thus have added security. GM has issued a series of converts, including the 6.25% issue (GPM) that trades near 17, below its face value of 25. It can be redeemed at the holder's option in 2018 at 25, resulting in an 11.9% yield. Given the low price, downside risk may be limited, short of a GM bankruptcy. If GM stock doubles from its current price of 20, the convert could be up 50%. The GM converts look good relative to the common shares and the company's nonconvertible debt, which yields 11% to 12%.

Mortgage Securities

Investors can play it safe and purchase funds like the low-fee Vanguard GNMA5 (VFIIX), which has more than 95% of its assets in government-backed Ginnie Maes, or take a little more risk with funds like the TCW Total Return Bond6 (TGLMX).

Given the complexity of mortgage issues, it pays to stick with managers who have demonstrated they understand that market. The managers of the TCW fund, Jeff Gundlach and Phil Barach, have been together more than 20 years and have put together a strong record for institutional and retail investors.

Their $1.4 billion fund has added significantly to its non-agency mortgage debt in recent months because prices got as low as 60 cents on the dollar. Gundlach says these issues carry current yields of 8% and could generate annual total returns well above 10%. Gundlach sticks with the top-rated tranches of prime and Alt-A mortgage securities. The closed-end TCW Strategic Income Fund (TSI) has about half its assets in mortgage securities. It trades at about $3.70 a share, a 13% discount to its net asset value.

The giant Pimco Total Return fund, with $127 billion in assets, roams the world in search of opportunity. It now has almost two-thirds of its assets in mortgage securities, and has bested its major rivals and its benchmark, the Lehman U.S. Aggregate bond index, in the past year, with a total return of 11%. TCW Total Return is up about 6%.

Municipal Bonds

Given strong gains in recent weeks, munis have become less appealing. Open-ended long-term muni funds are yielding about 4%, while closed-end funds can yield 5% or more.

The Legg Mason Partners Managed Municipals7 fund (SHMMX), run by veterans Joe Deane and Dave Fare, has a great long-term record. It also has done well in the past year, rising 5%, about four points better than the average long-term muni fund. The fund was defensively positioned for much of 2007 but grew more aggressive after munis tanked earlier this year.

FINANCIAL PLANNERS AND BROKERS typically advise investors to put some of their money in bonds. Now is a good time to diversify, given ample yields in many sectors of the market.


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(1) http://online.barrons.com/fund/snapshot.html? sym=PTTRX
(2) http://barrons.wsjprod.dowjones.net/fund/snapshot.html? sym=PRHYX
(3) http://barrons.wsjprod.dowjones.net/fund/snapshot.html? sym=PCONX
(4) http://barrons.wsjprod.dowjones.net/fund/snapshot.html? sym=FCVSX
(5) http://barrons.wsjprod.dowjones.net/fund/snapshot.html? sym=VFIIX
(6) http://barrons.wsjprod.dowjones.net/fund/snapshot.html? sym=TGLMX
(7) http://online.barrons.com/fund/snapshot.html? sym=SHMMX
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