Column: A brave new world for bonds

I find most investors follow the stock market very closely. They know the changes in market conditions can have dramatic effect on their portfolios and often will ask me about the current and forecasted market conditions on social occasions. The bond market, on the other hand, is a mystery to many investors and rarely will people wish to discuss the bond market casually with me. They realize it is important but they don't understand the many factors that drive fixed-income performance.

In this case, ignorance is not bliss. Big changes are under way in the bond market, due in large part to the shift from federal budget deficits to growing federal surpluses. The market for U.S. Treasuries - once the largest and most visible fixed-income sector - is gradually vanishing. As a result, many investors may need to adopt more sophisticated strategies for managing their bond holdings.

There's no question that a number of investors haven't seen the need to have any kind of fixed-income strategy in recent years. With the stock market posting double-digit returns, many investors came to believe that bonds no longer had a place in their portfolios. In fact, this is the first article I've written on the bond market in six months.

Over the long term, however, bonds have offered valuable benefits to moderate and conservative investors. Although historically they have paid lower returns than stocks, bonds tend to be more stable, reducing portfolio volatility. Bond and stock returns also have relatively low correlation, increasing the benefits of diversification.

Yet, I believe investors who recognize these benefits still don't always take full advantage of them. Instead of constructing a fully diversified bond portfolio, many investors simply build a 'ladder' of Treasury bonds, notes and bills, holding equal amounts of each and rolling them over as they mature.

While this strategy may be easy and inexpensive, it completely ignores a host of other fixed- income sectors - such as corporate and international bonds - that can enhance portfolio diversification and boost performance.

In my opinion, this is likely to be an even bigger disadvantage in the years ahead. With the federal government now collecting more in taxes than it is spending, the U.S. government is buying, not selling, securities. In the second quarter alone, the Treasury Department paid down a record $192 billion in outstanding debt. Such buybacks reduce the supply of Treasuries available to private investors. Already, the Treasury's share of the U.S. bond market is down to just 32 percent, from 47 percent in 1995.

Now, I remember from my economics classes at USC that when supply falls, relative to demand, prices will tend to rise. Many factors influence the demand for bonds, so it's not always easy to tell what's going on. But, Treasury prices have remained remarkably stable this year, despite rising interest rates and strong economic growth - usually bearish for bonds. Prices of some longer-term bonds, such as the 30-year Treasury, actually have risen since the end of 1999. This suggests the decline in supply is upward pressure on prices - and downward pressure on yields.

For investors holding existing Treasuries, all this is good news; rising prices mean higher returns. But, as older bonds mature and have to be replaced with new, lower-yielding securities, investors with laddered Treasury portfolios are likely to see a gradual decline in fixed-income returns.

How to cope with this trend? I would suggest holding more long-term Treasuries. Most of the time - although not at the moment - longer-term securities pay higher yields than shorter-term bills and notes. By extending maturities, investors could boost returns. But longer-term bond prices also tend to be more volatile, so investors who overweigh long Treasuries may end up taking on more risk than they want.

Another solution is to explore the rest of the fixed-income universe. Investors looking to diversify their portfolios can choose from a vast number of instruments, each with its own risk and return characteristics. I find that investment-grade corporate bonds, municipal bonds, mortgage-backed securities, and high yield securities may offer investment features to diversify your portfolio.

Investors who want to broaden their horizons face a number of obstacles, however. Transaction cost may be higher, for example. Even more importantly, investors need to recognize that fixed-income securities can carry large and sometimes unusual risks. Some instruments are structured to benefit from very specific economic conditions -and may post losses if those conditions are not met.

Unfortunately, I find the dwindling Treasury market has made such analysis even more difficult. For years, the Treasuries acted as benchmarks for the rest of the market. The difference, or 'spread' between a particular Treasury - such as the 10-year note - and a comparable private-sector bond provided a clear measure of the credit risk associated with each security. Now, however, Treasury spreads no longer provide an accurate measure of the credit risk associated with non-Treasury securities, mainly due to inaccurate Treasury pricing signals.

Under these conditions, most individual investors probably don't have the time or the skills to manage a fixed-income portfolio successfully. Fortunately, expert advice is available. By using the services of a professional investment manager, investors can reap the benefits of a diversified bond portfolio, while avoiding the complexities.

For more information on the availability of fixed-income options, call me, Bill Creekbaum, CFP at 689-8720 or e-mail me at william.a.creekbaum@rssmb.com