Easing Inflation Could Help Bonds

By Tim Paradis
Associated Press
Sunday, August 17, 2008

NEW YORK -- Investors who rushed to the relative safety of bond funds when the stock market began to stagger last year might have thought they had outrun the troubles in equities -- only to face the new threat of inflation when oil prices started soaring. But with the cost of crude now falling, some fixed-income investors could find themselves in an enviable position.

While economists and market watchers debate the reasons behind the drop that has left oil down more than $30 a barrel from its July 11 high of $147.27, most investors are probably simply relieved to see a pullback. In the case of bonds, lower prices for oil and other commodities can reduce the risks of inflation eating into returns. And if the decline in oil signals a slowing global economy rather than an overheated market taking a break, the sure-footedness of bonds could look even more attractive.

Most investors find it easier to rely on bond funds rather than trying to navigate the complexities of the bond markets. A fund also will probably mean holdings are more safely spread out over a range of investments.

Compared with the stock market, which has been pounded by the credit crisis, many types of bond funds have fared reasonably well over the past year. The credit problems have exacted a toll on riskier parts of the market, including the asset-backed debt that includes mortgages, car loans and credit cards. But government bond funds, for example, have held up.

However, despite bond funds' relative soundness, investors have been concerned about the problems that inflation poses for their holdings.

Paul Herbert, associate director of fund analysis at investment research provider Morningstar, said that though inflation was a "bond killer," investors also needed to consider whether a lasting pullback in prices would actually spur the economy.

"You've still got the growth side to worry about, so it's not full-steam ahead for bonds," he said.

So if the economy remains weak, investors in the safer parts of the bond market might fare better than in parts of the market more dependent on the health of corporations, for example. For investors willing to trade lower returns for safety, there are opportunities, observers say.

Bill Keller, investment director for greater Washington and Baltimore at PNC Wealth Management, said investors who might have strayed into areas with higher-yielding but riskier investments or those who are simply looking for other ideas might consider putting money into municipal bonds.

This part of the market appears on the mend after investors grew fearful of defaults at the start of the year. The muni market is traditionally attractive for its very low risk of debt going bad.

"Muni bonds are inexpensive today, and when you layer on a potential greater demand over the next year or two, it's even more attractive today," he said.

"In February, we looked and said every municipal bond is going to go bad," he said. Noting how quickly Wall Street's mood can shift, he pointed to comments from some market observers little more than a month ago that oil was headed toward $200 a barrel.

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