Bond outlook: Coupon rate to be the reward in new year; huge returns from '09 not likely to be repeated

The coupon rate will have to be the reward for buying bonds in 2010 since the fixed-income issues won't be producing the spectacular returns that were seen last year, bond managers and consultants say.

“2010 will be the year of the coupon,” said James Sarni, a managing principal at Payden & Rygel in Los Angeles.

Mr. Sarni said investors will be getting the bulk of those returns from the coupons of fixed-income products because spreads have tightened during the past few months and bond prices should be relatively stable.

That's a sentiment shared by other money managers and consultants.

“With Treasury yields still at historically low levels and spreads having returned to more "normal' levels, investors should expect single-digit returns at best,” said Ford O'Neil, Boston-based manager of core-plus portfolios at Fidelity Investments and its Pyramis Global Advisors institutional business.

The best strategy for institutional investors who'll be depending on the coupon rate for their returns is to avoid low-interest Treasuries and agency issues, say money managers and consultants.

“We would expect that over the next decade, core-plus managers are poised to outperform core on due to their heavier weightings to credit, versus the core mandates, which are generally laden with Treasuries and agencies that have low yields due to being risk-free,” said Eric J. Petroff, director of research for Wurts & Associates in Seattle.

For 2010, Mr. Sarni said he believes that corporate bonds rated BBB - still considered investment grade, and the top-rated categories of below-investment grade, BB, as well as emerging market debt, are good picks for investors because they typically offer coupon rates of at least 5%. But he is avoiding junk bonds with more lucrative yields because of their high risk of default.

He particularly likes bonds from companies like DirecTV Inc., debt classified as BB. He also likes debt from Albertsons Inc., another BB issue, which was issued before it was acquire by SUPERVALU Inc. He said both companies have shown they are viable players in their respective categories of telecommunications and supermarkets.

Mr. Sarni said since bonds from BB-rated companies are classified as higher risk and so pay interest rates between 7% and 8%, as much as 200 basis points more than investment-grade offerings, he said.

“We believe that a core-plus strategy will do better relative to core,'' he said. “The higher yield offered on a core-plus strategy is a big part of this view.” Payden & Rygel manages $7.5 billion in core strategies and $5.3 billion in core-plus bonds, both as of Dec. 22.

Emerging market debt is another option favored by many investment professionals. For higher returns, Mr. Sarni said Venezuela, with its 13% coupon rate, is an attractive choice.

“We believe that the bonds are attractively valued considering their sovereign status and the fact that the country enjoys considerable gross foreign exchange reserves, relatively low foreign debt as a percentage of GDP and high nominal GDP,” he said.

While another factor to consider with Venezuela is the loss of investor credibility should President Hugo Chavez nationalize more and more industries, Mr. Sarni said Mr. Chavez is unlikely to jeopardize his access to global capital markets when, as and if needed.

“In short,” Mr. Sarni said, “we think that the yield adequately compensates investors considering the aforementioned country fundamentals.”

He also likes debt from countries like Brazil, Mexico, Philippines and Turkey. “They are good solid countries, they don't have high inflation and they have stable governments,” he said. The stability, however, means the coupon rate on that debt will be paying around 5%.

Mr. Sarni and other fixed-income investment professionals believe that while better overall economic times domestically are ahead in 2010, continued high unemployment and high consumer debt levels will prove to be a roadblock that'll be tough to pass.

“We are at the beginning of a long, protracted recovery,'' Mr. Sarni said. “It's going to take a while for the leverage to turn around.”

Michael R. Ruff, portfolio manager with Russell Investments in Tacoma, Wash., said that while returns that reached as high as 100 % in 2009 won't be seen next year, Mr. Ruff said there still will be opportunities for strong gains in corporate issues, particularly given the spread between them and Treasuries.

“We see that the spreads are still meaningful,” he said. “They're higher than historical norms. On a relative basis, the fact that spreads and yields are elevated shows a strong argument for credit.”

Like Mr. Sarni, Mr. Ruff likes BB and BBB issues because he believes they offer solid yields, upward of 660 basis points above Treasuries, with limited risk.

Mr. Ruff said he is not sold on junk bonds because history has shown there's a high number of corporate defaults in that category.

He also favors buying non-agency mortgage-backed residential fixed-income bonds and commercial mortgage issues. Some of those securities might evoke unpleasant memories of the 2008 financial meltdown but Mr. Ruff said there are ways for institutional investors to minimize risk while maximizing returns.

Mr. Ruff said while defaults in the commercial real estate sector are expected to increase to 18% in 2010 from 8% this year, investors who buy into issues on the super senior level will be protected from the first 30% of losses. “It is a very compelling area,” he said.

Curtis Arledge, New York-based managing director and co-head of U.S. fixed income in BlackRock Inc.'s fixed-income portfolio management group, said the asset manager has been experiencing strong inflows from pension funds into core-plus investment strategies.

Mr. Arledge, like many managers interviewed for this story, believes that a key strategy for success in 2010 will be picking the debt issues of companies that are going to thrive. He likes the bottom levels of investment-grade corporate bonds and the top category of below-investment-grade securities.

“We believe it is a year of filtering out the winners from the losers,” he said.

Mr. Arledge also agrees returns will be in the single digits, except for riskier, lower-grade corporate bond offerings.

He said BlackRock is also looking at non-agency securitized mortgage issues and securitized commercial mortgage-backed securities. He said the securities can be tailored to the risk preferences of institutional investors.

He said his company is also interested in emerging market debt in countries where economies are building and continued growth is likely, such as Brazil.

The level of risk institutional investors want in the fixed-income area, however, varies tremendously.

Some institutional investors aren't comfortable with high levels of risk given the massive losses they experienced in 2008, said Alan Papier, a principal in the manager research group of Mercer's investment consulting business in Chicago.

While institutional investors regained much of the ground they lost in 2008, Mr. Papier said the volatility of the marketplace has not sat well with some of them.

“We are having conversations with clients as to how much alpha you really want to strive for,” he said.

On the other hand, he added, other institutions, particularly larger ones, are ready to take on the risk in an effort to maximize returns.

“In general, we found some clients are perfectly comfortable with the risks,” he said. “Some clients have replaced core managers with core-plus managers.”

He said conversations with those pension plans have revolved around investments in the higher categories of non-investment-grade corporate issues and non-agency mortgage-backed securities. He would not release names of clients.

The big unanswered question is how well the marketplace will absorb an expected $2 trillion in new Treasury and agency debt in 2010. In 2009, the $300 billion in net new supply in the Treasury market was absorbed by sovereign wealth funds, foreign central banks and U.S. citizens, said Mr. O'Neil of Fidelity and Pyramis.

That means buyers will need to increase their net purchases of Treasuries, he explained, and new buyers will be needed or rates will be pressured upward.

While bond markets are affected by tactical considerations and valuations, there is also a strategic shift happening, said Bob Collie, managing director, investment strategy and consulting at Russell Investments. That is pension plan executives are becoming more aware of risk, and in particular of the mismatch between assets and liabilities.

The shift is being influenced by corporate defined benefit plans and likely will continue to have an impact on bond markets in 2010, he said. The average corporate defined benefit plan has increased its bond allocation by just a few percentage points in the past couple of years, he added, as part of efforts to increase strategic allocations to this asset class over time.