Fixed-income fund returns have been within striking distance of many equity sectors since the beginning of the year. But then, that's not saying a lot. Leading the bond group have been high-yield, long government and emerging markets, the only three categories with 4%-plus returns.

But many factors may make it difficult for fixed-income funds to sustain their performance. Financial Advisor recently caught up with three leading bond-fund managers and asked for their views on what they are looking at as part of their decision-making process, and where they expect bonds to go from here.

Mark Kiesel, PIMCO

Executive vice president, a senior member of the investment strategy and portfolio management group, head of the investment-grade corporate desk and manager of corporate bond portfolios

"The big picture is that we're negative on the bond market in the near term because we think the Fed is going to likely raise the Fed Funds rate to 2% by the end of year," Kiesel says.

He believes inflation is accelerating, and he's keeping a particular eye on oil and the indirect effects it will have on consumer spending as well as the stock and housing markets.

But he's more optimistic about the longer term for the bond market. Toward the end of this year, he expects the ten-year to approach 4.75% and the bond market to become a buy. Why? He maintains economic growth is set to slow more than the consensus believes as higher interest rates impact today's leveraged economy by slowing economic growth.

"We're probably not going to have a recession. But here's the problem: We've been growing nominal GDP at 6% to 7%. I'm suggesting we'll be slowing down to the 4% to 5% range, closer to 5%. I'm also suggesting real GDP will slow to 2% to 2.5%, and we've been growing at closer to 3.5% to 4%. This will feel like a significant slowdown," Kiesel says.

He thinks a major factor contributing to the slowdown will be rising oil prices, which he believes will slow consumer spending. Rising interest rates over the next several months also will result in consumers tightening their belts, he says. A third factor, Kiesel says, will be an erosion of consumer confidence that will hurt the housing market.

Job growth, the stock market and housing prices drive consumer confidence, which is high considering poor job growth and weak equities, he says. "What's kept confidence high is housing. And here's the problem: What's caused the run-up in housing is rising debt levels," he says. "Here's the big thesis: Oil will now be the catalyst which leads to a deleveraging of the consumer balance sheet and a rise in the saving rate. The reason is that oil is an inelastic good; people need it, so they'll have less money to spend on other things. It will cause consumers to become more cautious, slow spending and take on less debt."

Housing will become increasingly vulnerable, he says, because what's supported the rise in home prices has been consumers' ability and willingness to take on more debt. Housing prices are now 10% to 20% overvalued, he believes. First we will see more houses for sale, and over the next several months offering prices will fall between 5% and 15%, he adds.

Kiesel says there's another issue related to housing. "Consumers have been using their house as an ATM machine. They've been withdrawing equity out of their homes, and these large mortgage equity withdrawals have supported spending despite weak job growth. Mortgage equity withdrawals should slow with higher interest rates and that, combined with a slower rate of debt growth, should subtract 1% to 1.5% from growth in consumer spending in 2005," he asserts.

As a result, the bond market will become a "buy" next year, he says, because the slowdown in consumer spending and housing will ultimately limit the rise in the Fed Funds rate. "The economy will put the Fed on hold. Right now the Fed is on a mission to normalize short rates to a more neutral level, and they probably will go to 2%. But the economy will put a stop to the Fed mission. Short rates will go up, but they will go up less than what the market expects," he says. What's priced-in now, he says, is 2% by the end of the year for Fed Funds, almost 3% by the end of 2005 and 3.5% by the end of 2006.

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