Stock-Addicted Investors Still Reluctant to Take the Bond Cure

For years they've been dissed by stock market snobs who found their widow-and-orphan-sized returns laughable. And during the past few weeks they've been battered by worries about everything from soaring oil prices to the sagging euro. But a look at the numbers shows some dramatic comparisons. Bonds have been, to use a technical term, kicking you-know-what this year. And despite the recent display of dot-com volatility , many experts expect the run to continue.

Take a look:

Bonds Rule
Index	YTD Return
Treasury Bonds	8.04%
Muni Bonds	7.08
Corporate Bonds	5.79
Mortgage Bonds	6.729
High-Yield Bonds	0.39
Nasdaq Composite	-9.3*
S&P 500	-2.9*
Dow	-7.5*
*Price change only. Source: Lehman Bros., Morningstar, Baseline. Performance through Sept. 26, munis through Sept. 22.

In a flat-to-down year for stocks, it's the bond investors who've got bragging rights. You go Grandma!

But can investors overlook the recent spate of crises that have helped push 30-year bond yields to nearly 6%, up from 5.66% in early September? Long-term treasuries , in particular, the star of the fixed-income market's stealth rally this year, suddenly have a lot to overcome:

• Oil prices are at post-Gulf War highs, making it harder to keep a lid on inflation.

• Traders are swapping long-term debt for shorter-term issues in anticipation that after six rate hikes in the past 15 months, the Fed is ready to move in the other direction.

• Treasuries are facing stiff competition from gigantic new issues of corporate debt, such as the recent $6 billion offering from Spanish telecom giant Telefonica(TEF).

• Investors have become skeptical that either presidential candidate will actually use the budget surplus to retire Uncle Sam's debt, keeping bond supplies short and prices high.

Add it all up and what you've got is a classic buying opportunity, the bulls maintain.

Inflation? Fuggedaboutit. So what if oil is the highest it has been in a decade? Core inflation -- excluding jumpy food and energy costs -- is a mere 0.4 percentage points above 35-year lows recorded in January, says Jim Paulsen, the resident bond bull and inflation skeptic at Wells Capital Management in Minneapolis. Other commodity indexes, including the Commodity Research Bureau spot commodity index and the Goldman Sachs nonenergy commodity price index, are below the lows reached during the Asian economic collapse two years ago, he adds.

We're not headed into inflationary oblivion. Instead, we're headed for a replay of 1995, Paulsen thinks. That's when bond returns matched those of stocks as the economy slowed and interest rates eased following a string of Fed hikes induced by the last significant inflation scare. That year, 30-year bonds returned 31% and the Dow Jones Industrial Average gained 34%. Stock market leaders that year were remarkably bondlike; the S&P financials gained 49%.

Before you start salivating, let me point out that Paulsen is looking for considerably more modest gains -- something in the teens for both stocks and bonds over the next year, while yields on Treasury bonds fall to 5% to 5.25%.

But you don't have to share Paulsen's outlook on interest rates to be bullish on bonds. And you don't have to place your bets on bipolar Treasuries either.

Vanguard's fixed-income chief Ian MacKinnon thinks interest rates are headed higher -- to 6.25% or 6.5% on the 30-year bond, as the economy proves stronger than many expect. Nonetheless, fixed-income investments outside the volatile Treasury area range from "excellent values" to "screaming buys," according to MacKinnon. Corporate bond yields are so much higher than Treasuries right now, investors appear to be assuming a cumulative default rate of almost 20%, he figures -- one out of every five corporate bonds. To put that in context, consider that during the Great Depression default rates maxed out at about 20%.

"When you can get 7% to 8% in a high-quality corporate, that's good value against any asset class," says MacKinnon. Ditto for agency and mortgage-backed bonds, says MacKinnon.

Below, a bond sampler of some top-performing funds outside the Treasury market:

Some Top-Performing Bond Funds
Fund	Type	YTD Return
(CFXIX)CGM Fixed Income	Corporate	10.39%
(UMLTX)Excelsior Long-Term Tax Exempt	Muni., Nat'l.	10.09
(SFIMX)SAFECO Insured Municipal Bond	Muni., Nat'l.	9.77
(VBLTX)Vanguard Long-Term Bond Index	Corporate	9.14
(ADMSX)Advantus Mortgage Securities Income A	Mortgage	7.54
(PTTAX)Pimco Total Return	General	6.51
Source: Morningstar. Performance through Sept. 26.

Why, you might ask yourself when you look at that table, has money been pouring out of bond funds all year? According to the Investment Company Institute, bond funds saw $40 billion in net withdrawals through July. Lipper estimates that another $4.3 billion drained out in August. Meanwhile, some $232 billion has gone into stock funds during this year through July, outpacing last year's $103 billion in the same period.

How can investors be so myopic? Simple, says Vanguard's MacKinnon. Not many were around during the 1970s, when stocks were the dogs of the market and bonds were the sexy holdings. During that decade the S&P 500 returned an average 5.8% a year -- behind the 6.4% return for T-bills, the 6.1% for corporate bonds and the 7.4% average annual inflation rate.

Look, you don't have to make like John Travolta and disco the night away. But would it kill ya to buy a bond or two?

Investors who simply can't overcome their stock addiction might substitute the "bonds of the stock market," says Paulsen. They include stocks that can continue to grow even when the economy doesn't, including health care issues (Merck (MRK), Eli Lilly (LLY)) and consumer staples (Wal-Mart (WMT), McDonald's (MCD)). Paulsen also likes rate-sensitive financials, as long as they're outside the banking sector, where credit quality worries might surface in a slowing economy. Better: Insurer American International Group (AIG) and mortgage-giant Fannie Mae (FNM). As for utilities, Paulsen prefers plain vanilla, "the ConEd's (ED) of the world."

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