Band on Bonds

11/18/2005 12:00 am EST

Focus:

Richard Band

Editor, Profitable Investing

Having initially built a reputation as a bond guru in the early 1980s, when yields were in double-digits, Richard Band says, "I never dreamed I'd call bonds a buy with yields at 4.5%." Nevertheless, he's now a bond bull and offers several favorite ideas for investors seeking income. 

"We’re now in the midst of what will likely prove to be the best opportunity of the next few years to buy high-quality bonds (especially Treasuries and municipals). Despite the recent energy-induced inflation scare, the world is still awash in excess supply of most goods (labor, too). Instead of letting inflation get out of hand, there’s a far greater risk, in my judgment, that the Federal Reserve will overextend its tight-money bias and push us toward deflation.

"We saw a spike up in bond yields during the summer of 2003, when it finally dawned on Wall Street that the global economy was entering a growth phase. Then, the ten-year yield peaked at 4.65% in August 2003, then crept slightly higher (to about 4.9%) in the spring of 2004 when US business activity hit full stride. Since then, despite continued brisk economic growth and a steep upturn in commodity prices (notably energy), the ten-year yield traced out a lower peak at 4.7% in March 2005. Another, still lower, peak seems to be forming now.

"A skeptic might retort: ‘But what’s to keep bond yields from breaking through 4.7%, then 5% and more?’ Obviously, I can’t guarantee they won’t. (Prices for most existing bonds would drop if yields went higher.) However, I think the odds are strongly against it. Not only does the chart of bonds suggest that yields are bumping up against a ceiling, but the smart money is betting that way, too. One indicator I’ve learned to respect is the positioning of the big commercial interests—bond dealers—in the futures market.

"Right now, the commercials are buying T-bond futures at a furious clip (even more aggressively than they’re slurping up oil). In fact, their net holdings of T-bonds, as a percent of the total open interest in bond futures, recently soared to the top 1% of all readings in the past ten years. As the great financier J.P. Morgan once said, ‘If you see someone who’s making a lot of money, do what he does.’ Year in and year out, the commercials earn their bread trading bonds. If they’re buying, I want to buy.

"At this stage of the business cycle, my favorite bonds are Treasuries. It appears that the best news for corporate bonds (including so-called ‘junk’ paper) is behind us. If the economy slows in 2006, as I expect, corporate default rates will tick up. You don’t want to be holding a lot of bonds whose ability to repay principal and interest is increasingly called into doubt. Treasuries, by contrast, give you a pure play on rates. Once investors see evidence that the Fed is near the end of its credit-tightening campaign, T-bond yields will fall—perhaps dramatically—and prices will rise.

"If you prefer to buy individual Treasuries through a broker, I advise you to stick with maturities longer than 20 years. In an environment of falling yields, these issues will chalk up the biggest gains. I suggest the 5.25% bond of February 2029, which should enjoy some of the strongest appreciation among standard, interest-bearing T-bonds. Investors should pay up to $1,066.25 per bond. We note that the bonds provide semiannual interest coupons to bondholders.

"For the model portfolio, our main Treasury vehicle is the no-load Wasatch-Hoisington US Treasury Fund (WHOSX), with a current yield of 4.2%. With either the Hoisington fund or the individual bonds, I’m looking for a total return—interest plus capital appreciation—of at least 10%, and perhaps a bit more, over the next 12–15 months. I’m also making room in the portfolio for a sliver of zero-coupon bonds through the American Century Target Maturities Trust—2025 Portfolio (BTTRX ). Because zero coupons pay no current interest, their prices tend to fluctuate more than do ordinary bonds of the same quality and maturity. Looking out a year or so, I’m shooting for a 15% return (or more) with BTTRX. Plan to earmark $3 to WHOSX for every $1 you put into BTTRX. Buy any day you find the ten-year Treasury yield quoted, during the day, at 4.5% or higher.

"I can’t leave the subject of bonds without touching on the bargains in the tax-exempt area. Specifically, I’m keen on certain closed-end municipal funds, which allow you to buy a portfolio of tax-free bonds at discounts ranging up to 10% of net asset value (and sometimes more). Thanks to the discount, many of these funds are yielding close to, or even a teensy bit bove, 6%. When you consider there’s no federal income tax on the interest, muni funds can offer a handsome advantage for investors in the upper income brackets. If you’re paying tax at a 28% rate, a muni fund yielding 6% is the equivalent of a taxable bond yielding 8.3%.

"Most closed-end muni funds are leveraged. In other words, they borrow money (at short-term interest rates) to buy more bonds. With the Fed boosting the cost of overnight money, quite a few funds have been forced to shave their dividends in recent months. However, I expect the process to reverse in 2006 as money market rates peak and then head down. Dividends will start to edge up again. My top buy this month is Van Kampen Trust for Investment-Grade Municipals (VGM NYSE).This fund, yielding a cool 6%, is trading at barely 85 cents on the dollar—one of the steepest discounts in the muni sector.

"The discount will likely narrow as interest rates drop, magnifying any gain in the share price. VGM also boasts a high-quality portfolio, with 87% of its bonds rated either AAA or AA. Best of all, you’re hiring first-rate management talent. On an NAV basis, the fund has outperformed Vanguard’s long-term municipal bond fund for the past three, five and ten years (through September 30). Any fund that can beat my Vanguard gold standard over the long haul is well worth adding to your cupboard. Buy VGM at $14.65 or less."

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