Secular, structural long-term reasons will prevent interest rates from rising sharply, Kiesel says. They include China's ability to export deflation through cheap labor and an almost zero cost for information and economic globalization. That's not to suggest we won't see inflation pick up on a cyclical basis, though, as a result of stronger demand from places like China, he adds.

Based on this economic outlook, how does PIMCO view different sectors of the bond market? Kiesel says some emerging markets are benefiting from higher oil prices, including Russia. "We are overweight or focusing on countries such as Russia," he says.

PIMCO is more negative on U.S. corporate bonds, because the spreads between them and Treasuries are tight, he says. High-yield bonds look a little more attractive than investment grade, he adds. The firm is cautious regarding companies whose business is cyclical or could be sensitive to higher oil prices, he adds; companies in retail, automobiles, airlines, lodging, real estate and even tech could be more affected by an economic slowdown. Instead, he's looking at more noncyclical businesses, such as media and cable, utilities, telecom, energy, health care and pipelines, because these sectors tend to be defensive, he says.

Dan Fuss, Loomis, Sayles & Co.

Vice chairman and co-manager of the Loomis Sayles Bond Fund

Fuss is monitoring four factors: the war in Iraq; the world economic outlook, including the price of oil and its availability; central bank policy in major currencies-specifically the dollar, euro and yen, but also a few others; and corporate earnings.

"Now you could say there's nothing new about those major factors. The one that's sometimes not there is oil. That's the general background. But we have a case in which the footnote is more important than the headline," he says.

The footnote is that the amount of leverage in the bond market is enormous, Fuss says, and that's a result of the U.S. central bank keeping the yield curve very steep in the face of an economic recovery. Short rates are still very low relative to longer rates and that provides an inducement to borrow short and invest long, resulting in a lot of liquidity for the economy, he adds.

But that liquidity could be sucked out if leveraged positions are liquidated too quickly because short rates rise too much too soon, he says. Although Fuss expects rates to rise, he doesn't think they'll rise that quickly. "All I can do about the future is guess, but based on the little I know about the present, I think we're in a modest cycle in interest rates. Mid-June 2003 was the low for 20 years or more. I think interest rates will go up quite a while and then down quite a while, and hopefully I'll be alive to see it," he comments.

He's guessing that during this interest rate cycle, the peak for short rates will be 3%; for the ten-year Treasury, 5.25%; and the 30-year Treasury, around 6.25%, but possibly higher if 30-year Treasuries are issued again, he says.


Rising interest rates won't be good for bond prices, of course, but they will be for funds being reinvested and new money entering the bond market, he says. The rate increases he expects imply a reasonable economy, Fuss says. Corporations aren't in a capital spending boom, so they probably aren't going to borrow a ton of money and get caught in a speculative frenzy, he comments.

The corporate bond sector, Fuss comments, is looking at decent credit trends for a long time. It's true that yields relative to Treasuries are narrow, but they are still quite wide compared with the last time Treasuries were at this level; that was 40 years ago, Fuss notes. "Corporates are a better place to be than Treasuries. You have a yield advantage, you don't have new issuance and you do have, sitting under the market, a tremendous reinvestment of coupons and other bonds presently held. And you do have strong offshore demand for U.S. bonds," he says.

While he does favor corporates over Treasuries, over the last two and a half years he's cut the duration of bonds held in the Loomis Sayles Bond Fund to a little over five from nine and the average maturity down from 19 years to ten.