A fresh look at the credit markets

Periods of volatility like we've experienced in the past year or so tend to be good reminders of how a sound asset allocation strategy - the spreading of funds across various asset categories such as stocks and bonds - can smooth out the spikes and drops that are an inevitable part of the financial markets.

This effect is one of the reasons that bonds and other fixed-income securities can play an important role in most, if not all, portfolios. But if you're like many investors you probably devote far less attention to your fixed-income holdings than you do the equity portion of your portfolio.

Modern bond investing often seems like a complex undertaking, requiring detailed knowledge of the credit markets' various sectors. These include Treasuries, agencies, municipals, corporate, mortgage backed, asset backed and international.

Each of these categories is defined by the issuer (the company, fund or government agency selling the bond), by the credit quality and by the source of the cash flows used to pay principal and interest. While all this may seem daunting to understand, what follows is a good way to think about the credit markets and how bonds can help your portfolio.

All fixed-income investments carry risk of loss even though for some, like short-term Treasury bills, the risks are so small as to be considered almost negligible. Potential risks range from interest-rate risk (or the potential for prices to fall as interest rates rise - this occurs when investors decide an existing bond's income stream is less favorable relative to the cash flow of a newly issued bond) to default risk (most fixed-income securities other than Treasuries carry some risk the issuer and may fail to pay interest and principal in a timely way).

The nature of these risks can vary widely from sector to sector. Mortgage- backed securities, for example, may lose value when interest rates fall as well as when they rise, because falling rates often lead homeowners to refinance outstanding loans. Under certain circumstances, this can result in steep losses for investors.

Fixed-income portfolio strategies can focus on a number of different factors, but two of the most important are the level of exposure to changes in the overall direction of interest rates, and exposures to changes in the relationship between rates for different maturities and issuers - also known as the yield curve.

If you have a strong view on the direction of interest rates, you might shorten or lengthen your portfolio's average duration (duration measures the sensitivity of a particular bond or bond fund to changes in interest rates, taking into account both the maturity of the bond and the timing of future principal and interest payments). The longer the duration, the greater the price change relative to interest rate changes. So, if you expect rates to fall, you might lengthen your portfolio's average duration to get the most from the corresponding rise in bond prices. If you fear an increase in rates, you might shorten your average duration to minimize or avoid capital losses.

Expected changes in the shape of the yield curve, on the other hand, might cause an investor to shift the distribution of maturities within a portfolio.

If you expect short-term rates to rise and long-term rates to fall, you might adopt the barbell strategy - buying securities with very short and very long maturities, while reducing holdings in the middle of the yield curve. This may produce capital gains at the long end of the curve while allowing you to reinvest in higher-yielding assets at the short end as rates rise.

A bullet strategy implies buying a narrow range of maturities or even a single maturity. This type of strategy makes sense for those investors who feel strongly about the direction of interest rates. If you feel rates will drop, allocating assets on the long end of the yield curve will allow for a capital gain if rates do fall. Conversely, if you think that rates are headed higher or if you need those assets soon, a short-term bullet will help protect those assets if rates rise. This approach also give you the flexibility to 'extend out' on the curve as bonds mature and long-term yields rise.

If you foresee little or no chance in the shape of the yield curve, you might choose a laddered strategy - spreading maturities evenly across the curve.

Selecting the right strategy, however, isn't nearly as simple as these examples suggest. But they do show some of the ways that prudent management can improve fixed-income performance, both by controlling risk as well as by exploiting shorter-term trends.

Bond investing is a complex undertaking, but also offers attractive potential opportunities - both in the range of fixed income assets available to investors and the techniques available for managing those assets. To take advantage of those opportunities, however, you should understand the market forces that influence your portfolio and decide how much risk you're willing to accept.

• For more information, please e-mail me at William.a.creekbaum@smithbarney.com or call 689-8704.