Ride the new bull market in bonds

By Tim Middleton

The bear market in bonds is over. Whether the Federal Reserve is done hiking interest rates or has only paused -- opinions are divided -- investors can be confident the highest-quality bonds are making money again.

"The new bull market in bonds has begun," avers Bill Gross, the chief investment officer of Pacific Investment Management Co. -- the fabled Pimco. It began in July, when investors became convinced rates would not be hiked at the Fed's August meeting. They were right.

Since then, intermediate-term, high-quality bonds, the most popular kind owned by mutual funds, have returned 2.5%. That is more than six months' of normal performance delivered in less than two.

And while equity investors think little about income, they should think a lot about bonds. They can greatly reduce risk in a stock portfolio, and when stocks are going up in single digits, as they are in these opening years of the 21^st century, they can actually increase total returns.

Here's a look at the various flavors of bonds, and the prospects for each right now:

Intermediate-term bonds

Unlike most bond gurus, Lehman Brothers does not subscribe to the notion the Fed is done boosting rates. "Lehman's view is that the Fed has paused, but we still anticipate rate hikes in October and then in January," says Adam Topalian, a senior Lehman Brothers investment strategist.

Despite this, he thinks short- and intermediate-term bonds will do well in coming months. Short refers to maturities of four years or less, and intermediate refers to the five- to eight-year range.

The bond funds that individual investors are most likely to own are of the intermediate type, including Gross' Pimco Total Return (PTTRX), the Gross-managed Harbor Bond Fund (HABDX) and the top-performing Metropolitan West Total Return (MWTRX), which is up 3.37% this year, as of Sept. 8.

Tad Rivelle, chief investment officer of Metropolitan West Asset Management, says his fund is stressing the highest-quality bonds, including Treasurys and government agencies.

High-yield and mortgages

The economy clearly is slowing, Rivelle says, and in that environment "you don't want to go near the high-yield market."

Bonds with the lowest credit ratings were so popular when the economy was booming that the market is now glutted with them, and their yields are little more than those of less-risky corporates.

What Rivelle calls the "easy lending practices of the last few years" have also led to an abundance of mortgage-backed bonds vulnerable to a housing market that is losing steam nationwide. He says that means steering clear of mortgage-backed bonds, which take it on the chin when rates are volatile.

Treasurys

Bond market financial futures, representing the collective opinion of the entire marketplace, are predicting a Fed funds rate of about 4.5% one year from now. That would imply three quarter-point reductions between now and then.

If the market is right and the Fed will soon begin cutting rates, it will do so to combat economic weakness. Treasury bonds prosper in that environment because competing investments look more and more vulnerable to agitation contagion.

Corporates

A soft economy is not good for risky bonds of any type, starting with investment-grade corporates. They yield more than governments because of their risks, but these days that risk premium is narrow by historical measures.

In a downturn the premium will rise, depressing their prices.

Foreign debt

Emerging-market debt will suffer because these bonds are bound much more tightly than the developed world to global economic growth. The domestic demand of such nations is relatively slight making them reliant on trade -- the more volatile component of economic activity.

Foreign developed-market bond funds, on the other hand, remain attractive. Both Europe and Japan are raising interest rates modestly, boosting their yields, and the dollar has been declining in value against the euro and the yen for several years.

Templeton Global Bond Fund (TPINX), which could hold U.S. bonds along with its overseas holdings, at present does not. "Foreign developed-market bonds are currently at the top of our list in terms of where we see value in today's marketplace," says Christopher Molumphy, chief investment officer of Franklin Templeton's fixed-income group.

While the fund can hedge currency risk, it is not doing so now, believing the dollar will continue to decline, especially against the yen and other Asian currencies.

Municipal bonds

Back in the home market, taxpayers in the highest brackets and those who live in high-tax states will find municipal bond funds an attractive option. T. Rowe Price Tax-Free Income Fund (PRTAX) has yielded 4.43% over the past 12 months, as of July. For someone in the 35% federal tax bracket that is equivalent to 6.82%. Comparable Treasury bonds are yielding around 5%.

The tax-free market does, however, have two pitfalls. One is that income from local bonds is usually free from state as well as federal taxes. Therefore, residents of high-tax states will prefer a state-only fund to a national offering like T. Rowe Price Tax-Free Income.

The other is that some tax-free bonds are not exempt from the alternative minimum tax (AMT), which affects an ever-growing number of taxpayers because it isn't indexed to inflation. The T. Rowe Price Tax-Free Income Fund is wholly free of AMT bonds, but many muni-bond funds put about 15% of assets into them because their yields are higher. If you are affected by the AMT, don't buy a muni-bond fund without checking its status.

At the time of publication Timothy Middleton owned the following securities mentioned in this article: Harbor Bond Fund. Middleton is the author of "The Bond King: Investment Secrets from PIMCO's Bill Gross" and is the former mutual funds columnist of The New York Times. He works from home in Short Hills, N.J.