Attractive values, demographics draw investors to bonds

Editor's note: The following is excerpted from a roundtable discussion with Pioneer executives Kenneth J. Taubes, senior vice president and head of fixed income; David J. Eurkus, vice president, municipal bond portfolio manager; Margaret D. Patel, senior vice president and portfolio manager, Pioneer high-yield fund; Richard A. Schlanger, vice president and portfolio manager, U.S. government issues; and Salvatore P. Pramas, vice president and portfolio manager, international bonds.

The Federal Reserve Board has brought down short-term interest rates by 2.75 percent since the beginning of the year. Lower rates have added to the positive returns that several fixed-income sectors have delivered since stock markets began tumbling early last year.

Yields are also attractive in several bond-market sectors, and equities seem unlikely to repeat their recent stellar returns particularly if an economic recovery is farther in the future than has been thought. Strong demographic forces are poised to boost demand for fixed-income assets. Pioneer Investments is encouraging investors and their advisers to use this opportunity to reevaluate asset allocations and rebalance portfolios as appropriate.

Evidence is accumulating that the slowdown here in the United States may extend into 2002, casting further doubt on stock market returns.

Bonds in several fixed-income sectors, including high-yield bonds, mortgage-backed securities and municipals offer an attractive combination of value and high current yields.

The thousands of baby boomers who are nearing retirement represent a huge pool of potential demand as they cut back their stock market exposure and seek to boost retirement income and increase portfolio stability.

Q. What lesson should investors be drawing from recent stock and bond market performance?

Taubes: It's a lesson that investors have heard before: diversification. There have been major, largely unforeseen shifts in the economic environment causing equity prices to decline significantly in many sectors. In the last 18 months, U.S. large-cap stocks declined by more than 15 percent, as measured by the Standard & Poor's 500 Stock Index, while the damage to the NASDAQ Index, a proxy for technology stocks, has been much more dramatic. Meanwhile, most bond markets have done much better, with investment-grade corporates, governments and municipals recording very positive returns.

We think equity returns will regress toward the mean the returns we saw in the '90s were certainly not typical of long-term equity results. So investors might do well to seek a better balance between risk and reward. Adding fixed-income holdings to their portfolios is a logical way to do that.

Q. Won't lower interest rates lead to higher stock prices?

Schlanger: Maybe so, but it may take quite a while. The Fed's rate cuts are the best evidence that the economy is slowing. Although the bulk of the cuts are probably behind us, more easing could be necessary.

Q. Haven't many bond sectors already risen quite a bit?

Taubes: They have. But we are convinced that many portfolios are still distorted in favor of equities. Meanwhile, baby boomers are heading into retirement in large numbers. As time passes, they will feel the need for more income and be less concerned about appreciation they'll want to protect their wealth from market volatility. This wave of retiring boomers is a demographic imperative that could increase demand for fixed-income securities substantially.

While there's little yield to be found in stocks, yields in most bond categories are very attractive.

Q. Where should investors be looking?

Eurkus: Let's start with municipal bonds, where investors can earn income that's free of federal, and some state, income taxes. The crossover tax rate the point at which individuals are better off in tax-free rather than taxable bonds is now below 30 percent in many cases. Meanwhile, the yield on 30-year AAA-rated munis was 92.5 percent of comparable maturity treasuries as of the end of June 2001.

All this means that for investors seeking a relative safe haven from the volatility of the equity market, munis are an attractive, tax-free alternative. The taxable equivalent yields are greater in most tax-frees than in comparably rated taxable corporate bonds. We also find these ratios attractive on a historical basis. In addition, according to Moody's and Standard & Poor's, the tax-free universe has substantially more credit upgrades than downgrades, in comparison to corporates.

Q. Is there enough demand to ab-sorb the supply of munis?

Eurkus: Absolutely. Municipals continue to benefit from positive institutional fund flows, increased allocation from money managers, and steady retail investment due to coupon maturities (reinvestment of principal) and baby boomers rebalancing in favor of bonds as retirement approaches.

Q. What other fixed-income sectors look attractive?

Taubes: Particularly in corporate sectors, spreads over equivalent-maturity treasuries are high, giving a nice yield cushion to compensate for risk while the economy remains sluggish.

Patel: For example, although high-yield spreads have narrowed somewhat they are still quite wide in historic terms. There are good values to be found. We continue to like energy even though oil and gas prices may soften for a time. An oil price of $18 to $20 is high enough to encourage drilling. We also think technology will rebound faster than the general economy, so we've been buying semiconductor manufacturers and telecom equipment makers. And real estate is looking attractive right now. Fears of a downturn have not been realized and lower rates have made financing easier.

Q. What's the outlook for international bonds?

Pramas: The outlook for global bonds is mixed; it is quite positive for high grade, sovereign bonds such as German Bunds, especially given the decline we anticipate in the U.S. dollar, but the outlook is still fairly risky for emerging market debt such as Argentina and Turkey.

In the high-grade sector, 10-year bonds issued by the governments of Germany, Canada and Australia offer yields slightly below or above the 5.10-percent yield of comparable U.S. Treasury bonds. But in addition to this yield, investors have the potential for significant currency gains should the U.S. dollar decline from its recent super-strong level. Our favorite bond in this sector is an inflation-protected French government bond that actually yields more than conventional French government bonds with no such protection.

In the emerging debt market things are not so rosy. Both Argentina and Turkey are in the midst of their own financial crises, and investors are beginning to suspect that some form of debt restructuring may be necessary in both countries in order to avoid outright default. Brazil is dealing with a weak currency and an energy crisis, Mexico is slowing down dramatically, and the entire Asian region is being hurt by the huge drop-off in world demand for their exports, namely technology and electronic goods. De-spite a significant rise in yields year-to-date, the risks are still too high to be too aggressive in the emerging debt sector.

Q. Which government bonds should appeal to individuals at this point?

Schlanger: The Federal debt pay-down program has taken more than $200 billion in long-term obligations out of the market, leaving a sizable unsatisfied demand for quality assets. We think mortgage-backed issues offer the best opportunities at this point. With less issuance going forward because of declining refinance activity in the housing sector, GNMAs now show a spread over treasuries of more than 1.6 percent. In addition, GNMAs are backed by the "full faith and credit" of Uncle Sam.

Q. How do investors make choices among all these possibilities?

Taubes: First, they should consult with their financial advisers to determine how much fixed income may be appropriate in each instance and what kinds. If an investor wants to gain broad exposure to the range of bond sectors, a single portfolio designed for that purpose ... may fit the bill.

(This article was provided by Pio-neer Investment Management Inc. of Boston, Mass.)