These days many investors are approaching the bond market with the view that what goes up must come down. In other words, with bond prices having gained sharply over the past two years, many investors are expecting bond prices to fall and yields to rise.

While this could well be true, it's important for investors to distinguish between the outlook for U.S. Treasuries and that of other sectors of the bond market. After all, the $19 trillion bond market consists of many other segments, including corporate bonds, government bonds, municipal bonds, mortgage bonds and agency securities.

The performance of each of these sectors can vary depending on the economic and financial environment. In general, investors should approach the bond market in the same way they approach the stock market by looking to capitalize on big-picture trends.

For example, in the same way that equity investors pick and choose between various industries depending on the economic outlook, the same should be done by investors in the bond market. Investors should examine the outlook for the various segments of the bond market by picking the best types of bonds for the current environment.

Improved Outlook

The outlook for the economy is fairly good, and the current situation tends to favor the corporate bond market. The basis for optimism on the economic outlook rests on cyclical and secular forces.

The main cyclical force is the low level of business inventories, which are now near an all-time low relative to sales. The main secular force is the enormous growth in business productivity, which still appears to be in its early stages of a multiyear rise owing to the application of new technologies.

A developing positive is the recent drop in the price of crude oil. The decline will put billions of dollars back into the hands of consumers. Each dollar decrease in the price of crude oil puts $7 billion a year back into consumers' pockets. With oil having fallen about $5 a barrel from its recent high, the stimulus could be significant.

Another important positive includes the massive mortgage-refinancing wave now underway. By some estimates, the refinancing boom will result in as much as $200 billion in cash-out mortgages (a cash-out mortgage is a new mortgage that's larger than the mortgage being refinanced). These cash-out dollars are still in the pipeline and will help the economy over the next few quarters, particularly the upcoming quarter.

New Power

The shift in power in Washington will add additional impetus to economic growth, as a new economic stimulus plan should pass early next year. Passage of a terrorism insurance bill will provide an added boost by lifting commercial construction activity.


Federal Reserve's

recent rate cut should further boost economic activity on top of the monetary stimulus already in the pipeline. If the economy does indeed improve, Treasury prices will likely fall very sharply. The yield on the 10-year T-note would probably rise to about 2.5 to 3 percentage points over the annual inflation rate. With the inflation rate at about 2%, this means the yield on the 10-year will probably reach 4.5% to 5% over the coming year.

Importantly, if the economy improves, prices on corporate bonds are likely to fall at a slower pace than Treasuries, and in some cases prices will actually rise. This is because a strong economy will boost corporate profits, thus increasing cash flows and reducing the risks of defaults. A falling default rate is favorable for the corporate bond market, particularly the junk bond market, which would probably rally sharply if the economy were to strengthen.

Of course, if the economy falters, then Treasuries would again become attractive. The inflation rate would likely fall, leaving plenty of room for Treasury yields to fall despite the currently low level of interest rates.

The yield on the 10-year T-note could easily drop from its current level of about 3.85% to around 3% if the inflation rate were to fall. If, in the remote chance the economy were to experience deflation, current Treasury yields would appear quite attractive, as the yield spread to the inflation rate would be wider than usual.