News Analysis
BusinessWeek.com
July 11, 2006
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Don't Bet on a Bond Rally

Bill Gross and other bond bulls are calling for a rebound, but it's not a sure thing. Why? An uncertain Fed outlook

Bonds are coming off a lackluster six months. One popular benchmark, the Lehman Brothers U.S. Aggregate Index, lost 0.7% in the first half of 2006, compared with a 2.5% gain for the same period a year earlier. Now some analysts say the tide may be turning, amid signs of a slowing economy and favorable price trends for Treasury issues.

Nevertheless, with inflation still a worry and the Federal Reserve expected to raise interest rates again at its Aug. 8 meeting, bonds may not be out of the woods yet. Until the Fed signals the end of its rate-hike campaign, investors should exercise caution.

Bond-fund guru Bill Gross has been among the most vocal forecasters of a turnaround (see BusinessWeek.com, 3/30/06, "Bill Gross: Harbor Bond Fund". "The bond bear market is beginning to go into hibernation, which is the same thing as saying the bear market is over," the Pimco chief investment officer said in a July 7 television interview. "While we're not about to reap huge capital gains, bonds will do better from here in terms of price."

A RALLY "NEAR"? He's not the only bond-market observer seeing positive signals. David Rosenberg, U.S. economist at Merrill Lynch (MER), also sees a potential lift ahead. Why? As of July 10, the entire Treasury yield curve is trading below the 5.25% federal funds rate. This scenario has played out only four times in the past 25 years, notes Rosenberg.

"Each of these preceded either a downturn in the economy, a major financial strain, or both," Rosenberg wrote in a July 10 report. "What transpired on average over the next six months was a major rally in the bond market, led by the shorter end of the yield curve."

Technical analysts, too, are projecting a bond comeback. Both daily and weekly indicators "may suggest that a rally in bonds is near and that yields have peaked or are close to peaking for the immediate term," noted Mark Arbeter, chief technical analyst at Standard & Poor's, in a July 7 report.

WAITING AND WATCHING.  The U.S. Treasury market, in particular, is enjoying increased investor optimism. A Ried Thunberg survey showed money managers are more bullish on government debt. The research firm's index on the outlook for 10-year Treasury notes through year-end rose to 57 on July 7, its highest level since Sept. 14, 2001.

Still, it's too soon to tell if a bond rally is really on the horizon, other analysts maintain. Unexpected changes in the outlook for inflation or Fed interest-rate hikes could sidetrack a recovery, according to Steven C. Shachat, senior portfolio manager of the Alpine Municipal Money Market Fund (AMUXX ) and Alpine Tax Optimized Income Fund (ATOIX ).

"While we're not quite as bearish today as we were six months ago, we're still standing on the sidelines a little bit until we get a greater understanding of what all this tightening has accomplished," Shachat says.

GO SHORT-TERM.  Even if the Fed chooses not to increase rates in September, the pause will likely only be temporary, according to Steven Ricchiuto, chief U.S. economist at ABN Amro. In the immediate term, he expects both stocks and bonds alike to drift. "A lack of fundamental information will leave the debt and equity markets looking for direction from both the currency and commodity markets, even though the [second-quarter] earnings season officially kicks off this week," Ricchiuto wrote in a July 10 report.

Until the Fed picture changes, fixed-income investors should stick with shorter-term securities, observes Kim Daifotis, chief investment officer of fixed income at Charles Schwab Investment Management (SCHW ). "An ultra-short bond fund has been ideal in this environment," Daifotis says. "It's not the time to go to longer-term bonds just yet."

Two funds to consider in this area are Fidelity Ultra-Short Bond (FUSFX ) and Payden Limited Maturity (PYLMX). Fidelity's offering posted an average annualized return of 2.33% over the past three years, compared with a peer average of 1.67%, with an expense ratio of 0.45%, according to S&P. Meanwhile, the Payden fund turned in an average annualized return of 1.92%, with expenses of 0.4%.

LOW-WORRY FUND.  Cost is a particularly important factor because lower-fee bond funds have typically had an advantage over their costlier brothers, according to Morningstar (MORN ) senior fund analyst Scott Berry. He likes the relatively inexpensive bond-fund lineups at Vanguard and Fidelity, including the Vanguard Total Bond Market Index (VBMFX ).

The fund has earned a three-year return of 1.82% on an average annualized basis, in line with its peers, and carries a price tag of only 0.2%. "It's not terribly exciting in that you're basically getting exposure to the entire investment-grade bond market, but it keeps costs low and it's a fund that investors really don't need to worry about," Berry says.

When bonds do rally, long-term bond funds would be expected to enjoy the biggest rebounds. One example, Vanguard Long-Term Investment Grade (VWESX ), is down 5.14% through July 7 and carries a 0.25% expense ratio. "If the market turns, that fund should turn right along with it," Berry says.

WRONG BEFORE.  Long-term Treasury funds, meanwhile, have shed about 3% for the year to date. These funds "are generally among the most volatile bond categories, but when rates are falling they do much better than any other," says Lipper research analyst Jeff Tjornehoj. Funds investing in Treasury Inflation-Protected Securities, or TIPS, may also have room for substantial improvement, Tjornehoj says (see BusinessWeek.com, 6/21/06, "Investor TIPS for Fighting Inflation").

While bonds can be an integral part of any portfolio, financial advisors generally advise against betting on fixed-income performance. "Fixed income is not for speculating on bear or bull markets," says Doug Taylor, a financial planner at Taylor Wealth Management in Torrance, Calif.

Indeed, today's bond bulls have been wrong before. Pimco's Gross has consistently undershot the Fed's interest-rate increases. In a January, 2005 outlook, Gross predicted that the Fed would keep interest rates "relatively low" and pointed to federal funds rates of 2.5%, 2.75% , or 3.5% as potential stopping points. The Fed has already raised rates to 5.25%.

The bond market may well be due to improve, as some analysts say. But investors may want to avoid going overboard in their bond exposure as long as the Fed's course remains unclear.