Of Bullets and Barbells
Picking a bond strategy means more than watching housing
It's not just home builders, real-estate agents, and Americans looking to buy or sell a home who are intently watching the nasty downturn in the housing market. Bond investors are totally focused as well. "Housing activity to a large extent has been really driving the direction of longer-term interest rates," says Andrew Stenwall, portfolio manager of the Nuveen Core Bond fund in Chicago. "As the housing market shows weakness, [government] bonds rally. And then as the housing market shows some resurgence or at least stability, then the 10-year [treasury note] tends to trade off."
Investors in government bonds tend to prefer bad economic news because they believe that faster growth may translate into higher inflation. And rising prices are poison for fixed-income investors. (Corporate-bond holders-particularly those who invest in high-yield bonds-may well prefer a more robust economy, since it strengthens company balance sheets.)
Jobs and income. So what is good for Main Street might well be bad news for Wall Street. But Nuveen studies indicate that new-home sales and housing prices have little long-term effect on consumer spending-certainly not as much as jobs, personal income, and the "wealth effect" from the stock market. And all of those factors look pretty good right now. The Dow Jones industrial average, for instance, has been hitting record highs and topped 13,000 last week.
Indeed, a new analysis from investment firm Goldman Sachs argues that consumption has remained strong because of offsets from rising equity wealth, which have allowed Americans' net worth to increase despite the housing downturn, and strong income growth (real disposable income is up at a 4.9 percent annualized rate over the past six months). So once housing stabilizes, Stenwall sees the economy reaccelerating, putting growth for the year at 2.5 to 3 percent.
If he's right, then government bonds may not be the best place for fixed-income investors right now. Stenwall is enthusiastic about high-yield corporate bonds, even though spreads between these issues and U.S. government bonds of comparable maturities are about 3 percentage points. That's quite narrow considering that less-risky treasuries are backed by Uncle Sam. Although the high-yield sector was the top fixed-income performer last year and so far this year as well-up 3.89 percent vs. 1.92 percent for the Lehman Brothers Aggregate Bond Index-Stenwall still thinks there are pockets of value. He has also been looking overseas to bonds issued by central banks in countries like Turkey and Brazil; the latter, he notes, has done an especially good job of curbing inflation. Bond guys love that.
Like Stenwall, Don Shute, fixed-income analyst for the IMS Strategic Income Fund in Portland, Ore., is also taking a pass on treasuries, but he thinks high-yield bonds are just too pricey. Because of low default rates, "they're about as expensive as you have seen in a decade," he says. "I prefer to look for the hated and overlooked." So the fund has been decreasing its holdings of investment-grade corporate bonds and increasing exposure to international corporate bonds, as the pressure of globalization increases business productivity in emerging markets. Shute is focusing on Latin American bonds-including from Argentina, Colombia, and Peru-since the region actually issues far more corporate debt than fast-growing Asia.
But if you are looking to put some money to work in U.S. government bonds, fixed-income chief Mary Miller of T. Rowe Price recommends a "bullet strategy" where investors concentrate their fixed-income holdings at one point in the middle of the yield curve, such as two-year and five-year notes. (There is also a "barbell" strategy, with a focus on the longest and shortest maturities.) "We expect the yield curve to steepen [with longer-term bonds yielding more than shorter-term ones] as we move into 2008, and the middle is a good place to be," she says. With decent yields and lower risk than the 10-year note, "this is the sweet spot of the yield curve."
This story appears in the May 7, 2007 print edition of U.S. News & World Report.