Most experts still bullish on bonds

With interest rates at record lows, experts agree that investors should still be holding bonds. The question is, which kind?

Financial advisers and economists say investors should have learned when the technology bubble burst that the only way to protect themselves from market swings is to be properly diversified.

But many advisers say that investors should consider which bond funds to buy, because it makes no sense to invest in individual bonds. It’s more expensive to buy and sell individual bonds than to buy and sell bond funds, they maintain.

eyeing longer maturity

Many advisers say they are placing investors in funds that invest in bonds with shorter durations. That protects against the possibility that the Federal Reserve has already cut interest rates as much as it can and that a hike in rates may not be far away.

“From a bond standpoint, we’re certainly selling off anything where a client has a longer maturity,” says Lou Stanasolovich, president of Legend Financial Advisors Inc. in Pittsburgh, which manages $150 million. “We’re trying to keep [maturities] to five years or less.”

Thomas Grzymala, president of Alexandria (Va.) Financial Associates Ltd., which manages $75 million, agrees.

“We’re taking capital gains [from bond fund sales] and parking them in short-term-bond funds,” Mr. Grzymala says. “We still want to keep a fixed-income portion to our portfolios; we’re just going to change the type of bond investment.”

The funds they recommend include the $13.6 billion Pimco Low Duration Bond Fund, the $259 million Thornburg Limited-Term Income Fund and the $1.4 billion Fremont Bond Fund.

The Pimco fund, offered by Pacific Investment Management Co. in Newport Beach, Calif., is a short-term-bond fund.

The Thornburg fund, offered by Thornburg Investment Management Inc. in Santa Fe, N.M., and the Fremont fund, offered by Fremont Investment Advisors Inc. in San Francisco, are intermediate-term funds. The Fremont fund is subadvised by Pimco and managed by its star bond fund manager, Bill Gross.

Not all advisers are sold on shorter-duration bonds.

Interest rates are at all-time lows, but there is still the possibility that the government won’t be able to raise interest rates anytime soon, says J. Michael Martin, president of Financial Advantage Inc., a Columbia, Md., firm with $110 million under management.

If that’s the case, investors would be giving up a lot if they got out of long-term bonds altogether, he says.

That doesn’t mean Mr. Martin recommends against investing in short-term bonds. He recommends that his client portfolios be 25% invested in such funds, and 20% each in intermediate-term- and long-term-bond funds, he says.

Two long-term-bond funds he uses are the $1.9 billion Loomis Sayles Bond Fund, offered by Loomis Sayles & Co. LP in Boston, and the $4.8 billion Vanguard Long-Term Corporate Bond Fund, offered by The Vanguard Group Inc. in Malvern, Pa.

government bonds

Economists aren’t much help in figuring out who is right when it comes to the duration debate.

James Paulsen, the Minneapolis-based chief investment officer of Wells Capital Management Inc. of San Francisco, points out that the yield of the 10-year Treasury bond, currently hovering at around 3%, has been in that neighborhood only two other times since 1800.

“It doesn’t give much hope that rates will go a lot lower, and it suggests … perhaps violent upside movement in yield,” he says.

If that happens, he argues, the best place to be is in short-term bonds.

But Michael Cheah, a vice president responsible for investment-grade fixed-income investments with SunAmerica Asset Management Corp. in New York, says he doesn’t see any evidence that the Fed will raise interest rates, thus hurting the bond market. He says all the evidences points to the Fed’s lowering rates even further.

For example, mortgage rates have started to creep up from recent lows. That means that a prop that has helped keep the economy up – by allowing many home owners to refinance – is weakening.

“There’s no way they can raise interest rates, because – God help us – we will be in a depression,” Mr. Cheah says.

Given such a situation, he says, he has no problem investing in long-term bonds.

Determining duration, however, is only part of the puzzle when it comes to deciding what bond in which to invest. Investors must also decide what type is best.

Again, there is little consensus.

Many financial advisers say they no longer believe it makes sense to invest in Treasuries, because they’re too expensive.

Stephen Gorman, president of Hingham, Mass.-based Gorman Financial Management Inc., which manages $100 million, says he prefers buying higher-yielding short-term corporate bonds, as opposed to Treasuries. He also likes municipal bonds.

Lewis Altfest, president of L.J. Altfest & Co. Inc. in New York, which manages $150 million, notes that yields for muni bonds are more attractive on a tax-free basis.

Two bond funds Mr. Gorman recommends are the $23.5 billion Vanguard Short-Term Corporate Fund and the $6.1 billion Vanguard Limited-Term Tax Exempt Fund.

Mr. Gorman is also using Treasury inflation-protected securities.

Tips are one of the only types of investments that are guaranteed by the government to repay the original bond principal upon maturity, as adjusted for inflation. Many advisers are buying them through mutual funds, and a few even are buying them individually.

If investors are convinced interest rates will go up, however, there are few such places where bond buyers can hide. Another may be junk bonds.

Mr. Altfest says he’s maintaining his exposure to high-yield bonds on the premise that they’ll prosper if the stock market goes up and bonds head south. Mr. Altfest likes the $7.3 billion Pimco High Yield Fund.

Charles Lieberman, investment strategist and chief economist with Advisors Financial Center LLC in Suffern, N.Y., agrees that junk bonds may be the right place for those investors who aren’t willing to get out of the bond market altogether.

Meanwhile, Mr. Gorman has taken some of his bond profits “off the table” and gone more into equities, but he hasn’t moved his clients completely out of bonds.

Harold Evensky, chairman of Evensky Brown & Katz, a Coral Gables, Fla., firm with $350 million under management, is taking the same approach.

He has shortened the duration of the bond funds in his client portfolios and is looking more seriously at investments such as Tips, but he hasn’t changed his clients’ allocation to bonds.

Mr. Paulsen suggests that investors look at corporate bonds. He expects real gross domestic product growth to improve in the second half of the year, averaging 4% to 5%.

In addition, corporate profits have risen in each of the last five quarters, and company inventory liquidations have turned to mild inventory additions in recent quarters, Mr. Paulsen says. Such events point to a recovery in the stock market and a drop in the bond market.

Mr. Cheah disagrees. In addition to rising mortgage rates, wages aren’t increasing, and therefore consumer spending isn’t rising, he points out.

That doesn’t bode well for the stock market, meaning there may still be some life in the bond market, Mr. Cheah says. Given such a scenario, long-term Treasuries may be the best bet, he says.

For advisers, such conflicting insights provide little help. But most experts agree that bonds, in whatever form, should remain part of a diversified portfolio.