Time For Bonds?

Once in a while the stock market sends investors a jolt to remind the financial world that bonds, too, make good investments. One clear signal that investment portfolios need balance came in July, when for one brief moment, the Dow closed above 14,000 only to bounce around in a series of dramatic point swings — closing as much as 1,000 points lower in less than a month.

Enter Mary Pugh, president and chief investment officer of Pugh Capital Management in Seattle (No. 13 on the be asset managers list with $1.1 billion in assets under management). Pugh got her start in the fixed-income market by working for Washington Mutual Bank for 10 years before setting up her own shop in 1991. Her firm sorts through the bond market, in which finance professionals trade in the debt and obligations issued by the U.S. government, federal agencies, state and local jurisdictions, and big corporations.

Pugh and her team focus on two bond characteristics for her institutional clientele, which includes the likes of the University of Washington, the City of

Seattle, and Boeing Co. First, because the bond market often moves in the opposite direction of the major stock indices, the fixed-income holdings she selects work as a good counterbalance to her clients’ equity holdings. Second, bonds can also pay a steady stream of income over time. Put the two characteristics together, and you have a prudent investment that protects money yet earns a steady return.

One primary concern for Pugh is the current level of interest rates, the bond market’s principal driver. When rates rise, the value of outstanding bonds issued at a lower interest rate drops. When rates head downward, the price of bonds previously brought to market at a higher rate increases. Currently, Pugh says rates are likely to drift downward over the next year. Meanwhile, the bond market is responding to a variety of factors. Several corporations, such as Daimler-Chrysler, Alltel, and Sallie Mae, are in the process of bringing bond issues to market in order to finance buyouts, and Pugh says the fixed-income marketplace will need time to assess and price a wave of new issues.

What’s your outlook for the economy?
We look for economic growth to continue to moderate in 2007 and 2008, and we think inflation will trend lower as a result. We don’t see signs of a recession, but there are a few things that will drive the economy to be weaker. For one, consumer spending will come under pressure, and there will be a decrease in disposable income. Consumer outlays have been a major factor fueling economic growth in the past few years. One big reason consumers have less to pump into the economy is that the housing sector is having ongoing difficulty, the subprime lending market in particular. We see more price deterioration for the housing market as well — a considerable amount, although we don’t expect a huge drop.

Where’s the bond market’s sweet spot?
Already after the stock market’s bumpy summer, we see a flight to quality — a large number of investors are turning to surer holdings such as Treasury bonds. In turn, that has raised the value of Treasuries in

the market. Whenever the Federal Reserve lowers rates, investors have a sign that the economy isn’t doing particularly well, and then, again, they turn to Treasuries. We look for the Fed to begin lowering rates, and thus five- and 10-year issues will provide the best total return.

How does this translate for individual investors?
Typically, bond story recommendations are hard for individual investors to put to use. Instead of paying a brokerage fee, investors pay a markup for bond trades. That’s why I would generally recommend investors look at bond mutual funds. However, I think these selections provide a good entry point in the bond market.
The first is a high quality municipal bond. The current market offers a very good opportunity to invest in five- to 10-year insured general obligation bonds that are issued by municipalities to cover expenses and finance specific projects. They are a safe investment and individual investors can check reports issued by credit rating agencies such as Standard & Poor’s, Moody’s, or Fitch to verify the solvency of the local government issuing the

bond. On top of that, there is another layer of security in the form of an insurance to back the bond that local governments are required to purchase. The average yield for the municipal bond sector according to the Lehman Brothers index for the group is 4.23%. Plus the investment gain is tax-free. For instance, someone in the 35% tax bracket would have to find an investment that returned a guaranteed 6.5% in order to match a municipal bond yield of 4.23%.

What’s your second favorite idea?
Treasury STRIPS, or Separate Trading of Registered Interest and Principal Securities, are a great interest rate play. Essentially, they are a Treasury bond investment that does not offer interest payments but instead appreciates in value over time. They also offer an opportunity to appreciate in value when interest rates fall. Currently a Treasury principal strip that matures Nov. 15, 2021, yields 5.27% and is priced at $47.52 (Note: An investor who purchases the strip at $475.20 can cash the bond in for $1,000 when it matures in 2021.)