Have you checked your index fund lately? The S&P 500 index is below its value of five years ago. Boring bonds? Well, the Lehman Brothers Aggregate Bond Index is up an average of 6 percent a year.
So will the party continue? Maybe not. "There are clouds entering the picture," warns Mark Kiesel, head of the investment-grade corporate desk at bond giant Pimco. Marilyn Cohen, president of Envision Capital Management and author of The Bond Bible, agrees: "The outlook is not as peachy as it has been."
Slowdown? The two bond managers arrive at the same forecast via different reasoning. Kiesel says consumer spending will slow, crimping corporate profits. As a result, bonds of companies without strong balance sheets and cash flows will suffer. Cohen blames active equity investors. They're pushing companies to reward them with stock buybacks, dividends, and mergers and acquisitions, all of which deplete the pool of funds available to pay bondholders. "The natives are restless; they want shareholder value unlocked," says Cohen. "That's poison for bondholders."
Either way, with profits expected to wane and companies back in spending mode, credit-rating agencies will be on the hunt to downgrade (GM and Ford were cut to junk status last year).
For that reason, both Cohen and Kiesel are fleeing to safer shores. They like bonds issued by government agencies like Freddie Mac and Fannie Mae. "Juicy yields and high credit quality," is how Cohen describes them. She recommends the 2007 and 2008 agency bonds because they sport yields of 5.05 percent to 5.1 percent.
Kiesel especially likes mortgage pass-through securities. "They're high quality and very cheap," he says. The current yield on these government-guaranteed bonds is around 5.75 percent, more than a percentage point higher than that of 10-year treasuries. You'll find bond funds loaded with them.
Tax-free municipal bonds are also a good bet, especially for investors in high tax brackets or for those who think taxes have to rise eventually to close the federal budget deficit. And if foreigners begin selling off their U.S. assets, as some economists predict, they'll sell treasuries, which they own, not munis, which they generally don't. For investors with the smallest appetite for risk, treasuries are still the investment of choice. "They're great now, 4.38 percent yield for two years, yahoo!" says Cohen.
As for corporate bonds, Kiesel's advice comes from the racetrack on a rainy day: "Favor the mudder." In other words, switch to bonds of companies that can perform in bad economic weather. They're found, he says, in the energy, pipeline, utility, media and cable, telecom, healthcare, and tobacco sectors. And upgrade to these higher-quality bonds now, he adds, "when the sun is still shining." -Matthew Benjamin