Defensive Bond Bets

03/25/2005 12:00 am EST

Focus:

Ivan Martchev

Editor, Vital Resource Investor and Global Viewpoints

"It’s long been our contention that the bond market is smarter than the stock market and for mutual fund investors, we continue to recommend defensive bond funds," says Ivan Martchev, editor at Wall Street Winners. Here, he highlights two favorites.

"The massive decline in below-investment-grade (junk) yields during the past two years signaled an economic recovery that continues to amaze many market participants with its resilience. The economy has (so far) withstood oil at $55 per barrel, which resulted in gas prices more than doubling for most consumers, and a commodity boom driven by emerging market demand that's threatened to accelerate inflation. But it hasn't succeeded in doing so in any material way yet.

"There have been a couple of interesting happenings in the bond market in 2005, though, that are relevant to mutual fund investors. First, long-term interest rates have declined substantially in the face of another Federal Reserve short-term interest rate hike. They've been declining since the first time the Fed hiked rates last June. During the past 50 years, long-term interest rates have risen every time the Fed has started on a rate-hiking cycle. Also, since January 1, the spread (difference) between riskier BB-rated junk bonds and Treasuries, which have been declining for the past two years, has started to noticeably widen. This is how investors behave when they're worried about the economy. It may be a false alarm, but we won't know until mid-2005.

"With this uncertain background, we are currently emphasizing defensive bond funds and two top fund recommendations in this area are  Vanguard Inflation-Protected Securities (VIPSX ) and T. Rowe Price International Bond (RPIBX ). Vanguard Inflation Securities only invests in inflation-protected Treasury bonds. And since its 2001 inception, it's never lost money. While even the most defensive investments have the occasional down year, this inflation-protected fund has a proven performance. It boasts one- and three-year annualized returns of 7% and 10.6%, respectively, with only a 0.18% expense ratio.

"Meanwhile, T. Rowe Price International is down 1.5% this year, largely due to the fact that it doesn't hedge its currency exposure. However, we don't invest in mutual funds with a one-quarter horizon and we expect that its unhedged position will be a benefit looking out over the next 12 to 18 months: It's well worth it to be a T. Rowe Price International Bond shareholder. Both funds are good core holdings."

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