Bored Treasuries Investors Look to Corporates for Better Value

A Treasury rally through 5% could be in the cards, but investment pros are focusing on corporates and high-yield near term.
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Up three ticks. Down four ticks. Unchanged.

Such has been the pattern of daily Treasury trading for the past two months.

The late-summer rally in Treasuries was a product of instability in the financial markets and the brief corrections in the stock market. But the yield on the 30-year Treasury bond has been stuck between 5% and 5.4% for most of the past three months, dipping below 5% only briefly.

With that in mind, investors say their fixed-income strategy isn't as obvious as last year's. Perhaps weary of watching range-bound Treasury trading for three months, managers believe other products, such as corporate and high-yield bonds, provide better value at this time. But even if Treasury bonds trade in this range for the next month or so, some fixed-income managers believe bond yields could rally through 5% based on the positive inflationary outlook and more expected weakness in emerging-market economies.

' I think Treasuries are OK,' says Liberty Funds' Carl Ericson. 'But the spread product is more attractive. Since it didn't follow the rally, I expect more tightening.'

Even though the

Federal Reserve

has likely moved to a neutral stance, inflation expectations remain low enough that further rate cuts cannot be completely discounted. "Inflation has been modest even in a period of respectable growth," says Carl Ericson, director of taxable fixed-income at

Liberty Funds

. "We've been in a trading range from 5% to 5.4% for months. Now, we're still in that trading range with high volatility. But I think fundamentally that

yields will go to the down side. The focus goes back to the economy."

The core

consumer price index

, an inflationary gauge, is currently 2.4%. The real rate of return (the current yield minus the core CPI, equaling about 2.8%) is better than in most of the other major financial economies. Fed Chairman

Alan Greenspan

signaled in

remarks last week that equity prices are not the first concern with regard to monetary policy.

If the rate of inflation continues to fall, it gives the Fed wide latitude to lower interest rates down the road, something managers are holding out hope for. During 1998, the Fed demonstrated that strong growth does not translate to rate hikes, especially if inflation is kept in check; its proclivity to stand pat is unlikely to change even if the manufacturing arena recovers in a big way.

The positive inflationary outlook carried the Treasury market only so far last year. Simply buying the Treasury curve and kicking up one's heels isn't going to fly for the next several months, says Mitch Stapley, manager of $3.5 billion in fixed-income at

Kent Funds

in Grand Rapids, Mich.

"Certainly in the last couple years, if you weren't long, you were wrong," says Stapley. "But with the market in a fairly narrow band, it's really a question of getting back to the spread product."

Stapley says he sees value in investment-grade corporate debt, still trading at relatively wide spreads. He's maintaining a slightly longer duration than the average index in the expectation that Treasury bonds are going to continue to do well, but he believes this type of play isn't going to drive returns in 1999. "I don't necessarily think we're going to get the huge flight to quality that drives us to 4.75%," he says. "This is a year where durations and capital gains aren't going to be the biggest part of your performance. You're going to be clipping the coupon off that spread product."

'Recession-Type Spreads'

But corporate bonds, especially riskier and more illiquid high-yield and emerging-market bonds, will be exposed to risk if more countries undergo market-related problems. And the erosion in corporate profits will make those bonds less attractive if they tighten significantly. The

Bear Stearns High-Yield Index

is trading at 590 basis points above the 10-year Treasury. That's better than in September, when spreads were at 650 basis points -- but not much.

"Corporate and high-yield bonds are still at recession-type spreads," says Geoffrey Kurinsky, manager of the $1.2 billion

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MFS Bond fund. "Our view is we'll see a slowdown, not necessarily a recession. You're getting paid in those markets -- but the big risk to those markets is a bigger slowdown. I think they're OK, but not a screaming buy."

Investors such as Kurinsky are more bullish on Treasuries based on their expectation for a stock-market correction or more dislocation in other financial markets. Most agree that the economy will continue to chug along, especially if the manufacturing sector recovers, and that the low inflationary environment and low commodity prices will help keep the Fed on hold for a while.

Kurinsky views Treasuries as valuable on a medium-term (six to nine months) basis due to the "extraordinary" inflation outlook and likelihood of more "shock events," such as Brazil's recent devaluation and potential for China to do the same.

Ericson is straddling the line between buying Treasuries and dipping down into the riskier sectors of the market. In the high-yield arena, he's sticking with less cyclical industries that aren't exposed to emerging markets, such as cable and media issues. He believes the fundamentals support lower yields in the Treasury market, but he isn't expecting a rally of last year's proportions.

"I think Treasuries are OK," he says. "But the spread product is more attractive. Since it didn't follow the rally, I expect more tightening."