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New Fed Chairman's Arrival Doesn't Change Growing Allure of Bonds

By Joe Bel Bruno
Associated Press
Sunday, February 12, 2006

The departure of Alan Greenspan and arrival of Ben S. Bernanke at the Federal Reserve have done nothing to deflect mutual fund investors from the big question: When will the Fed stop raising rates?

The question makes stock investors nervous, especially after last week's big drop in equities. But some bond fund investors may have their hands around a bottle of champagne.

Some analysts think both camps are wasting their time.

"Does it matter? No," said Margo L. Cook, who oversees $6 billion of assets as head of institutional fixed income for Bank of New York's BNY Asset Management. "Right now, investors should be thinking about diversified asset allocation."

Cook and other industry experts think mutual fund investors should consider bond funds as ballast for stock-heavy portfolios regardless of when the Fed ends its cycle of rate increases.

No one is suggesting that investors flee into bond funds because Wall Street, uneasy after 14 rate increases since 2004, is on the verge of a bear market. They think stocks still have plenty of momentum. What analysts recommend is that stock investors take a broader look at their portfolios because the bond market seems to be a relatively good bet right now.

Many analysts specifically point to bond funds that focus on short-to-intermediate maturities -- two to 10 years. There is history behind their advice.

In the past few decades, long-term bond funds have provided investors the highest rate of return, especially during interest rate declines. But those investments -- which in some cases mature at 30 years -- are more volatile because they are extremely sensitive to interest-rate fluctuations.

Short-term and intermediate-term bonds may be exactly what the financial planner ordered. Short-term bonds mature in less than two years, while intermediates expire in about 10 years. Historically, these funds are the ones to watch in the immediate aftermath of the Fed's decision to stop raising rates.

Between 1994 and early 1995, the Fed raised rates seven times, to 6 percent from 3 percent. Intermediate-term bonds then spiked 17.8 percent. In 1999 and 2000, the Fed sent rates up six times, to 6.5 percent from 4.75 percent -- and, once finished, intermediate-term bonds logged a 9.7 percent return, according to data provided by Morningstar.

Some analysts predict double-digit returns in the coming year for funds that track intermediate-term bonds. Already this year, investors have sent intermediate-term bonds up 1.8 percent in anticipation these investments will follow history. Intermediate-term bonds also delivered a 5.3 percent annualized return over the past five years.

"I think it's reasonable to start looking at bond funds," said Todd Barre, vice president and senior investment strategist for Harris Private Bank. "If an investor is quite aggressively in equities right now, I think it is reasonable to diversify given the fact short funds give a nice yield."

Some of the strongest bond funds this year include American Funds Bond Fund of America (ABNDX), Columbia Income (LIIAX), Summit Bond Fund (SABDX) and Pimco Total Return Institutional (PTTRX) . All have returned three-year annualized returns of over 5 percent.

Andrew Clark, a senior analyst with Lipper Research, said he sees fairly substantial returns this year for intermediate-term bonds. Lipper's model bond portfolio is currently weighted 50 percent in corporate bonds -- half of that in triple-B-rated bonds and the rest in high-yield.

Among the bond funds he suggests is Alliance Bernstein Corporate Bond Fund (CBFRX) , Morgan Stanley Income Fund (IISBX), the Delaware Delchester high-yield fund (DETWX) and the Goldman Sachs High-Yield Fund (GSHAX).

"I absolutely agree to stick with intermediate-term bonds because the returns are probably fairly substantial," he said. "But a smart investor might even consider going long. That's where the most money is going to be made, and once the Fed starts slowing this will be the next place investors look to."

Clark and other analysts aren't calling for a rush into the bond market. Instead, they're urging investors to think about where the Fed will likely freeze rates at -- 4.5 percent and 5 percent seem to be the most common predictions. Then find investments that traditionally will surpass that. Intermediate-term bond funds fit that bill, they say.

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