Creating a Winning Bond Strategy

With the right approach, bonds can achieve outstanding returns in a volatile market.Here's how.

bond performance will be much slower. “The tailwind for bonds has abated,” says Edwin Ek, chief investment officer of RhumbLine Advisers in Boston (No. 3 on the BE ASSET MANAGERS list with $7.4 billion in assets under management). “There’s no doubt that we’ve hit bottom and are bouncing back up.”

Some analysts are even more gloomy. “We think we’re in a bond bubble,” declares Mark Lay of MDL Management in Pittsburgh (No. 5 on the BE ASSET MANAGERS list with $3.81 billion in assets under management). Lay’s firm, which specializes in bond investing, believes interest rates have stayed low for so long because investors around the world have turned to bonds as a safe haven to park their money in light of so much global uncertainty. That huge demand has boosted long-term bond prices and sunken yields.

But Lay says economic changes are afoot. The U.S. gross domestic product is now growing at 4% a year, a healthy clip of economic activity after the recession of 2001 and 2002. When the economy is doing well, investors prefer stocks, so they’re likely to pull money out of bonds, causing prices to fall and rates to rise.

Another argument that rates will rise is that inflation, long thought dead, has recently resurfaced. Just look around. Job-based health coverage costs are 60% more today than they were five years ago. Home prices in areas like California and Nevada have surged 80% in the last three years, according to the National Association of Realtors. Inflation, the byproduct of increased economic activity, is every bondholder’s fear because it erodes the total returns of fixed-income portfolios.

To curb inflation, the Federal Reserve raised short-term rates six times, from 1.0% to 2.5%, since June 2004. But the Fed only controls the shortest rates. The market takes care of the rest. Ten-year Treasury yields haven’t budged at all; in fact, they’ve fallen. In January 2004, the 10-year logged a 4.26% yield. A year later, it had a 4.19% yield. With yields so stubbornly low, it might be a cue that all the hype about the improving economy may be just that.

“I think that bonds will have a decent year,” says Mary Pugh, president and CEO of Pugh Capital Management in Seattle (No. 15 on the BE ASSET MANAGERS list with $674 million in assets under management). “They’ll be in more of a trading range, with a possibility that rates will go down.”

Pugh’s view of bonds stems from her bearish thoughts on the economy. She believes that globalization and technology will put downward pressure on inflation and employment. At the same time, economic activity could be moderate because the refinancing boom has slowed and consumers don’t have as much money in their pockets to spend. Overall, Pugh thinks the 10-year bond could end the year just about where it started.

“I know I may be in the minority,” says Pugh, but it often pays to heed contrarian calls. A year ago, the investing pros thought interest rates were going to rise too. They

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