Mixed economic signals are allowing bonds to defy expectations.

    Financial advisors who have been taking defensive measures in anticipation of rising long-term rates and falling bond prices may have wait awhile longer for their strategies to shine.
Mixed economic signals and strong demand have been working to keep bonds holding their ground, and then some. Over the last year, in fact, most types of bond funds have seen solid gains in the face of predictions that they would move into negative territory after the Fed began its series of interest rate hikes in 2004.
    Sometimes, it seems that any news is good news for bonds. The devastation caused by Hurricane Katrina, coupled with surging gas prices around the nation in late August and early September, should have been bad for bonds. But they weren't.
    Market watchers predict much of the same through at least the first half of 2006. "It's hard to see long-term rates on Treasuries getting over 5%," says Jim Cusser. senior vice-president and portfolio manager at Waddell & Reed. "There is just too much demand and not enough evidence of inflation."
    Marc Levesque, chief fixed-income strategist for T.D. Economics, says that with signs of inflation growing stronger, today's bond rates are "simply too low to be sustainable." Still, he believes, "it is unlikely that we will return to 6% yields any time soon." He forecasts a ten-year Treasury yield of 4.55% by year-end, with perhaps another 20-basis-point increase by spring 2006.
    If history is any guide, it wasn't supposed to happen this way. When short-term rates go up, long-term rates usually follow suit. Earlier this year Fed chairman Alan Greenspan wondered aloud about the "conundrum" of persistently low rates on government bonds in the face of inflationary pressures and higher short-term rates, which many observers predicted would drive bond prices down and yields up well before the summer. But by the end of June the yield curve spread, defined as the difference between the ten-year U.S. Treasury rate and the federal funds rate, had been chopped from 180 points at the end of March to an 80-basis-point sliver. Even China's currency revaluation in July, which some thought would send shock waves through the bond market, created only minor ripples. As autumn approaches, bond prices continue to hold the course as the Fed contemplates even further tightening.
    One reason why bonds have shown so much resilience is the mixed messages investors are getting about the economy. Despite ten consecutive increases in the Fed funds rate between June 2004 and August 2005, the Fed contends that "core inflation has been relatively low in recent months" while "pressures on inflation have stayed elevated." Those pressures include the rising Consumer Price Index which, excluding food and energy, increased by 2.2% from the second quarter of 2004 through the second quarter of 2005, up from a 1.8% increase in the same period a year earlier. Real GDP has been growing for 14 consecutive quarters, averaging 4.4% per quarter since the middle of 2003. And the rising price of oil has been making headlines, vaulting to over $66 a barrel by August, up from $43 a barrel in January.
    Amid evidence of price inflation, the rate on bellwether ten-year Treasuries has actually decreased this year and is now about 60 basis points below its level of a year ago. For long bond rates to rise, investors have to believe that inflation is gaining a solid footing and will continue. Many aren't convinced that will happen.
    In a recent letter to clients, Oak Associates chief investment strategist Edward Yardeni argues that while the inflation rate has picked up a bit this year, it is still very low compared to the previous three decades. Cheap foreign labor has kept wage growth in this country modest, while "cheap imports from low-wage countries like China have helped keep a lid on consumer goods inflation." The manufacturing sector slowed significantly in the second quarter, leading some to the conclusion that the economy was slowing and the Fed had done enough tightening.
    Ken Taubes, director of fixed-income investing at Pioneer, believes that inflationary expectations remain low because investors had been preparing for a worst-case scenario that didn't come. "When the dollar weakened in 2003 and 2004 and commodity prices began to rise, inflation expectations began building up," he says. "Once people saw that the worst wasn't going to happen, inflation concerns began to subside."
    As inflation expectations stay in check, high bond yields on U.S. government securities relative to the rest of the world continues to attract foreign buyers. In mid-August, when the ten-year Treasury securities yielded 4.27%, similar maturity German bonds yielded 3.29% and Japanese bonds were yielding 1.43%.
    An economy on solid ground has also provided the bond market with ballast. "Money goes to places where people see some growth," Cusser says. "China is peaking, Japan is in the doldrums and Europe is on its back. Bond buyers see the U.S. as the place to be."
    Strong demand for bonds goes beyond foreign buyers, though. Pension funds are buying more longer-term bonds to do a better job of matching their assets with long-term liabilities. An aging population seeking safety likes the certainty of income associated with longer-term, fixed-income securities. On the corporate side, companies have kept supply in check by limiting their use of debt and refinancing old bonds at lower rates rather than issuing new ones.
    But the delicate balance that is keeping long bond rates low could topple if short-term rates get high enough for investors to reconsider their dedication to longer-term bonds, contends Jim Midanek, chief investment officer at Midanek/Pak Advisors in Walnut Creek, Calif. "Clearly, there is a lot of money chasing bonds now," he says. "But that could change if the Fed keeps raising short-term rates and investors begin moving down the yield curve to shorter maturities."
    Midanek also questions whether inflation is as benign as investors seem to think it is. "Eventually, fundamentals will win out. And the fundamental truth is that this is a very strong economy that won't necessarily be weakened by a Fed funds rate of 4% or 4.5%," he cautions.
    Another wild card is the long-term impact of China's currency revaluation, since China and other Asian investors have been heavy buyers of U.S. bonds and now own about one-quarter of all such debt. With the revaluation, China may see less need to buy dollars to hold its own currency down.
    After an initial jolt following the July revaluation, the bond market settled down when China's central bank issued a statement saying that it would not allow a sharp rise in the value of the yuan. Still, the longer-term impact of the move remains unclear. Eventually, long-term interest rates in the U.S. could rise if China and other Asian countries allow their currencies to appreciate rapidly and sell their U.S. bonds. However, economists say the Chinese are unlikely to do so because such wholesale dumping would decimate the value of their dollar-denominated assets, while a significant revaluation would drive up the price of the country's exports and make them less competitive with U.S. goods.

Strategists Stress Caution
With the longer-term outlook for bonds so uncertain, some fixed-income specialists are straddling the fence by taking advantage of higher short-term rates while preparing for the possibility an eventual increase in longer-term bond rates.
    Cusser is "diversifying along the yield curve" with a barbell approach, buying short-term and long-term securities instead of loading up on intermediate-term bonds with five- to ten-year maturities. "It's one way of admitting that you don't know where rates are headed," he says. "I'm willing to give up a little current yield in exchange for better gains and less severe losses if interest rates change." He's also been using corporate "put" bonds, which allow buyers to redeem prior to maturity at face value on specified dates without penalty. Investors may do this when interest rates are rising and they can take advantage of higher rates elsewhere.
    Given the healthy demand in most corners of the bond market, Taubes says he "can't describe anything as particularly cheap right now." He notes that credit spreads-the yield spreads between junk and investment grade bonds-are so narrow that investors aren't being paid much of a risk premium. Because spreads are so tight high-yield bonds, which are usually much less sensitive to interest rate fluctuation than investment grade securities, have lost some of that immunity. "This may be a good time to upgrade credit quality in bond portfolios," he advises.
    Taubes also believes that Treasury Inflation Protected securities (TIPs) are looking more attractive now than they have in a while, because their real yields increased from 1% in May to nearly 2% in August. For those inclined to wait things out, cash and short-term investments present a more appealing option than they have in a long time. In August, the Federal Reserve raised the Fed funds rate to 3.5%, and Levesque's forecast calls for another 0.5% increase by the beginning of 2006. Given tight credit spreads, the likelihood of an increase in short-term interest rates and a flattening yield curve, "the argument for cash and ultra-short investments is a compelling one," says Midanek.