It's a bond picker's market. Beware of corporate releveraging.

    Michael Roberge, chief fixed income officer at Boston's MFS Investment Management, thinks investors have a good chance of seeing decent returns from certain pockets of the bond market this year. But they need to pick their spots carefully.
    "It's a security by security analysis that's going to matter in the market over the next year or two," he says. "The name of the game in fixed income now is owning the market but avoiding the mistakes."
    From Roberge's perspective, investors have ample reason to keep bond money in play even as interest rates on intermediate- and long-term fixed income investments look poised to follow the rising trend at the shorter end of the yield curve. "There's not much yield in the equity markets, and people who are looking for income from their investments don't have a lot of options," he says. "Besides, almost everyone expected bond rates to climb last year, and they didn't."
    The bond market in 2004 indeed defied expectations by posting gains even after several interest rate hikes from the Federal Reserve. In a year that many predicted would be marked by negative returns for fixed-income investments, the average U.S. taxable bond fund returned 4.54%, according to Lipper. High-yield and world income funds did even better, posting returns of 9.89% and 9.84%, respectively. Even U.S. Treasury securities defied predictions of price erosion, with the yield of the ten-year benchmark ending the year about where it began. A number of factors, including strong participation by foreign investors in the U.S. bond market, helped keep bond prices stable.
    But this year presents a new set of challenges that could make foreign investors more skittish about investing in U.S. bonds, says MFS Chief Investment Strategist James Swanson. In a recent market commentary, Swanson noted that U.S. Treasury prices "have the potential to be strongly affected by dollar weakness because a significant part of the Treasury market is comprised of non-dollar-denominated investors." And with the U.S. savings rate near zero, compared to 10% of disposable income two decades ago, "overseas investors are financing most of the federal deficit." Those investors are becoming increasingly concerned that the growing U.S. budget deficit will erode the country's economic health, and rates may need to rise to attract these offshore buyers.

    Still, Roberge thinks that while rates may trend higher, the climb will not be substantial. He sees the Fed Funds rate increasing to 3% over the next 18 months, and a rate of around 5% to 5.25% for ten-year Treasury bond within three to six months. He believes the fund's benchmark, the Lehman Brothers Aggregate Bond Index, may be able to "eek out a positive total return this year. But it will be a close call."
    Another problem is that the slim difference in yield between Treasury issues and corporate bonds makes it more difficult for investors in the latter type of securities to realize capital gains from narrowing spreads. Recently, high-quality corporate bonds yielded only about 80 basis points more than ten-year Treasuries, he says, while high-yield "junk" bonds beat Treasury bond yields by about three percentage points.
    "If you look at the high-grade market from November of 1991 all the way to 1998, the spread was tighter and basically didn't move for seven years," he says. "The reason is that we are in a business expansion. We are probably in that type of environment over the next several years, so we expect spreads to remain tight."
    Roberge thinks that spreads between high-yield bonds and Treasuries have enough room to narrow a bit more this year, and that in a rising rate environment corporate bonds will likely outperform interest-rate-sensitive Treasuries. "The place to find value in fixed income is the corporate credit markets because of the fundamental improvement we are seeing," he says. "Companies have record levels of cash on the balance sheet and high levels of interest payment coverage, providing solid underpinnings to these markets."
    As the head of the team that manages the MFS Research Bond fund, an intermediate-term investment grade offering, Roberge needs to keep a significant portion of the fund in Treasury notes, agency securities, and mortgage-backed bonds to maintain the portfolio's average credit quality at a high investment grade level of AA-. He also keeps the fund's duration neutral relative to its benchmark. Currently, the fund and the benchmark have durations of four-and-a-half years.
    Roberge relies on credit analysis, rather than interest rate adjustments, to boost returns. He also has leeway to overweight or underweight corporate bonds and other non-U.S. government securities relative to the index. Since its inception in 1999, the fund has outperformed the Lehman Brothers Index and its Morningstar intermediate-term bond fund category average for five out of six calendar years. Its three- and five-year annualized yields are in the top 6% and 3%, respectively, for the group.
    The fund's current sector stance reflects a conviction that corporate bonds will outperform government issues this year.  Recently, the portfolio had about half of its assets in Treasuries and government securities, including agency issues and mortgage-backed bonds, compared to about 70 % in such securities for the Lehman Index.
    Companies at the higher-quality end of the junk bond spectrum that are on the cusp of receiving a credit upgrade from the major bond rating agencies are of particular interest. When that happens the prices of those bonds often get a boost, because pension funds and other institutional buyers that have credit quality restrictions can buy them. 
    Two years ago, the fund used this strategy by buying Tyco bonds soon after the company's management problems made headlines. Convinced that Tyco had ample asset coverage and generated sufficient cash flow to meet its debt obligations, Roberge moved in after the stock dropped substantially and the bonds were downgraded from an A rating to below investment grade. Last year, the major rating agencies upgraded Tyco to a low investment grade rating and the bonds responded favorably. Another long-time holding, bathroom and kitchen fixture maker American Standard, crossed into investment grade territory last year after it shored up its balance sheet and paid down debt.
    To select securities that are good candidates for an upgrade, Roberge and his team of analysts look for companies that have a proven management team, competitive positioning in the marketplace and strong free cash flow. They also like to see strong indenture provisions and solid collateral.
    While free cash flow is usually a plus, Roberge cautions that some companies are using it to benefit stockholders at the expense of bondholders. "With companies awash in cash, the bad news in the credit markets is the growing pressure by stockholders to add debt to buy back stock and implement dividends," he says. "We've seen examples recently of companies sacrificing their investment-grade rating by adding debt to their balance sheets and becoming a junk company to do a share buyback."
    He cites former fund holding HCA as one company that took such a route when it decided to take on a significant amount of debt last year in order to proceed with a share buyback. With a sizable chunk of leverage added to its balance sheet, the rating agencies downgraded the hospital and health care facility holding company's bonds. On the other hand, fund holding TXU Corp., a Texas utility, used leverage in a share buyback but still managed to keep its balance sheet healthy and avoid a credit downgrade.
    "We understand that equity holders provide capital, but companies need to balance their interests with those of debt holders," he says. "TXU has done that."
    While MFS Research Bond fund also owns a sprinkling of emerging market debt to perk up returns, Roberge believes investors will need to modify their expectations for the sector this year.  "In 2002, when we saw a deterioration of corporate credit quality in the U.S., the credit quality of the emerging market countries was improving," he notes. "With political reforms and corporate restructuring, about half of the emerging market bond index is now investment grade. There's been enormous appreciation in this category, but we won't be seeing that over the next couple of years." Still, with emerging market debt yielding about 400 basis points over Treasuries and potential for further credit improvement over the next decade, he believes the asset class remains "relatively attractive."