Unfortunately for fixed-income investors, there's no telling how long today's low-rate environment might last. Many think it could continue for some time. But virtually no one thinks that this environment will last forever.
Jerry Webman, director of fixed-income at Oppenheimer Funds, predicts it could be more than a year before rates turn up. "It's going to be a year from now before we see a sustainable economic growth of 3%," Webman says. "I think we have considerable time before rates rise materially." Others say the rise could begin toward the end of the year. With all the uncertainty, the burden is on financial advisors to pick up yield with little risk.
Many clients with fixed-income investments in their portfolios already have experienced a dramatic cut in income over the past year. They are rolling over 5% one-year CDs to those paying 2.5%. Money funds are yielding less than 2%, and five-year Treasury notes are paying less than 4%.
If, in fact, low interest rates are here to stay for a while, advisors say some clients must make changes. "Retired people are frightened to look at CDs with 1.5% to 2% yields," says Kathy Muldoon, CFP, and vice president of Carter Financial Management in Dallas. "They feel like they want to stretch out for more yield immediately. The best help I can give them is to (tell them to) think beyond the next three to nine months."
She says her retired clients are cutting expenses, as well as their retirement-savings distributions. To boost income without excessive risk, she has purchased high-grade corporate and agency bonds. She ladders the bonds so that they mature when clients take distributions from retirement-savings accounts. And she searches nationwide for the highest-yielding CDs by checking brokered rates and Bankrate.com.
Many advisors and bond managers are being cautious and not chasing yields at the longer end of the yield curve. The big danger: Once the economy picks up steam due to rate cuts and government stimulus, rates could rise, and bond prices could get pounded.
"There is a lot of interest-rate risk at the long end," says Michael K. MacMahan, CFP, and certified investment-management analyst with Raymond James in Gastonia, N.C. "We are keeping the duration of our fixed-income portfolios at 4.5 years."
MacMahan says that last October, he picked up yield by selling Treasury securities and buying corporate bonds for nontaxable accounts. In taxable accounts, he puts the money to work in municipal bonds with maturities of no longer than seven or eight years.
"The spread between governments and corporates is too wide," he says. "There are real opportunities in middle-grade corporate bonds. There are some recognizable names and asset-backed securities rated single A to single B.
"The economy will be picking up," MacMahan adds. "We could see growth of 3% to 4% the last half of the year. A lot of our bonds will be candidates for corporate upgrades. These are small companies, where the rate cuts have gone straight to the bottom line."
Bonds that MacMahan bought for clients include CDS Holdings, a railroad bond that yields 7.625% and matures in five years; Harrah's Entertainment, which yields 7.875% and matures in 2005; CS First Boston, a puttable bond that yields 6.4%; and Allied Waste, which yields 7.875% and matures in 2009.
Muldoon is taking another approach. She put about 2% to 5% of client assets in alternative investments yielding 7%. These include real estate offerings, such as the Cohen & Steers and Invesco Real Estate funds, as well as multisector closed-end bond funds, like MFS Charter Income Trust and Putnam Premier Income. Both funds own a combination of U.S. government securities, high-grade and junk bonds and dollar-denominated foreign government bonds.
Jim Swanson, senior vice president in charge of fixed-income strategies at MFS in Boston, does not expect rates to rise later this year. He cites Fed Chairman Alan Greenspan's recent comments that the economy is stabilizing, but there still are risks out there. His implication is that the recession could last longer than expected. The big problems are weak profits, business investment and restrained household spending caused by rising unemployment.
"We take a different view," Swanson says. "The recession came about because business spending declined. Industry had too much capacity and overinvestments. The demand for capacity utilization is 75% and still coming down. There is no near-term demand to push rates up."
Swanson says that following the last five recessions, rates fell during the initial stages of the recovery. Rates did not go up for 8 to 12 months after the recessions were over. He also sees no inflation risk. "Business has no pricing power," he stresses.
Swanson says high-grade corporate bonds now represent the best values. He sees the spreads between corporate and Treasuries narrowing. So there's an opportunity to pick up yield as well as capital appreciation.
As the recovery continues, he says, high-yield bond spreads will narrow. Junk bond prices also will rise as investors move into stocks. For the 12 months ending in January, junk bonds were up more than 7%.
Webman of Oppenheimer says the company's Strategic Income Fund is picking up yield in bonds with split BBB and BB ratings. These companies have stronger balance sheets and cash flow than others in the high-yield sector. The bonds yield 10% to 11%. "The economic view colors how we invest," Webman says. "We think there are sufficient yield spreads in that sector. There is enough certainty about the pace of the economic recovery to invest in high-yield bonds."
Ian MacKinnon, managing director of fixed income at the Vanguard Group,
believes high-medium to upper-grade bonds represent the best value. "The bond market represents good value right now relative to equities," MacKinnon says. "High-quality bonds are probably a safer bet, given the greater liquidity. Maturities of three to 10 years represent the best tradeoff between risk and return."
Swanson sees the bond market delivering solid returns this year. Over the next year, he estimates that corporate bonds will return 7% to 9.5%.
Meanwhile, junk bonds could register double-digit total returns. "When people begin to take on risk and buy stocks, they also buy other types of securities with upside potential and more risk."
Nevertheless, Swanson is not an outright bull. Bond defaults could hit 10% this year. As a result, MFS' bond funds keep their durations at 4.5, with bonds maturing in the two- to eight-year range. He will not barbell portfolios unless short-term rates start to rise and long-term rates fall.
Swanson recommends investors keep a core holding of short-term
Treasuries and agency paper, and 10% should be invested in high-yield bonds, with the rest in investment-grade bonds.
Mackinnon advises against investing in Ginnie Mae bonds because of the rapid acceleration in mortgage prepayments.
On the municipal-bond side, MacMahan is sticking with insured and AAA-rated paper. Revenues are down, and governments are eating into their surpluses. He is barbelling those portfolios to pick up some yield. This way, he can earn a high, blended rate of return. And if rates rise, he can roll over shorter-maturing bonds at high yields. In the meantime, his clients are earning high taxable-equivalent yields that are in line withthose of Treasury securities.
James Klotz, president of First Miami Securities in Boca Raton, Fla., says laddering municipal bonds is a bad move. The reason: Investors can buy long-term, insured tax-free bonds that yield nearly twice as much as U.S. Treasury bonds. Someone in the highest tax bracket could buy an insured A-or AA-rated bond that yields from 5.5% to 5.875%. That translates into a 9%-plus taxable-equivalent yield. By contrast, 30-year Treasury bonds are yielding 5.4%.
"Investors buy tax-free bonds for long-term income," Klotz says. "Our market is cheap compared to Treasuries. I would avoid laddering because you are sacrificing 40% to 50% of your income. Low inflation, commodity prices and recession hardly constitute a formula for rising rates anytime soon."
Klotz only puts his clients in long bonds. He does not trade them. At year-end, however, if bond prices are down, he swaps them for bonds with similar coupons and maturities. Then clients can write off the losses.
Currently, he recommends A-rated tobacco bonds. They are underpriced, he says, because investors think tobacco companies issue the bonds. But it's states, which are raising funds in the municipal-bond market based on tobacco settlements. The master settlement agreement between major tobacco companies and states provides more than $200 billion to the states over the next 25 years. With a fizzling economy and government budgets in disarray, states are tapping the settlement money. The bonds are asset-backed securities because the tobacco companies service the debt.
Of course, there is always a risk that tobacco companies could run into financial problems. But Klotz looks to ratings from Moody's Investors Service Inc., whose analysis concentrates heavily on the legal protection for the bondholder. Moody's, he says, "seeks to insure that the legal structures are sound, cash flows are protected and even a highly unlikely bankruptcy of one of the leading tobacco companies would not disrupt payment."
Bonds he favors include a Louisiana tobacco bond that yields 5.875%, as well as an Iowa bond with a current yield of 6%. He also likes a Connecticut Health and Educational Bond, which yields 5.5% to maturity and is rated AA and insured.