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Where the Value Is in the Bond Market, Part 2

Here's a roundup of the corporate, municipal, mortgage and agency bond sectors.

Editor's Note: This is part two of Brian Reynolds' bond market roundup. Be sure to check out Part 1.

As promised, here's a full rundown on bond market sectors and where I see value. Today, I'll focus on the spread, or non-Treasury, sectors. To find out what I think about the long and short ends of the Treasury market, please read

Wednesday's column.


The next question is what to buy. For me, one of the first places to look is investment-grade corporate bonds. I'm already overweighted there, so I'm concentrating on the intermediate-term area. This means I'm swapping maturity risk for credit risk. With current spread levels having been exceeded only four times in the past 25 years, I think I'm getting paid to take this risk.

Some people might not be comfortable with credit risk in a recession, but the wide spread levels already are discounting a nasty credit cycle. Contrast that with the still-high price-to-earnings ratios on many popular stocks. If you're uncomfortable with corporate bonds, you shouldn't own any stocks, either.

Corporates haven't done as well as the rallying long Treasuries. The 10-year Treasury's yield has fallen by about 24 basis points since Oct. 30 and by about 64 basis points since Sept. 10. However, a BBB-rated 10-year corporate bond's yield has only fallen by a few basis points since Oct. 30 and only about 13 basis points since Sept. 10.

The stresses in the corporate bond market

have been growing all year, and they're intensifying as year-end financing pressures mount.



is now the latest issuer unable to roll over maturing commercial paper (short-term borrowings usually issued to money funds) and must now issue long-term debt in the bond market. It'll be issuing debt in the five-, 10- and 30-year area at rates between 6% and 8%, instead of issuing commercial paper at 2.5%.

This deal won't be priced until next week. With the dealers' November year-end approaching, this issue is a critical sign for how the corporate-bond market will trade through year-end. As with the




General Motors


deals last month, there should be a lot of bids for this paper, but some will come from traditional high-yield buyers looking for relative safety. If the AT&T deal forces other corporate spreads higher, either in the investment-grade or high-yield sector, I'd be a better buyer.


I'm also adding to the municipal-bond sector. Of course, this decision depends on your tax rate, but munis look very attractive to me. They've lagged behind other sectors in this rally, and some munis are now yielding more than Treasuries.

Some of this underperformance is fundamentally justified. Many munis are callable, so they tend to lag in a rally, and the economic downturn has weakened municipal budgets. However, I think the selling has been overdone. Many insurance companies have significant muni holdings and have had to sell after Sept. 11. At current spread levels, munis offer an attractive long-term opportunity, and if bond yields go back up, munis should be one of the best-performing sectors.


I sold some of my mortgages

early last month because I felt I wasn't being compensated enough for the prepayment wave that would happen if we got a modest decline in bond yields.

We did get that drop in bond yields, and refinancings are starting to surge. However, mortgage spreads vs. Treasuries still seem too tight to me, partly because people are paying up for the credit safety that mortgages offer. In normal times, mortgage spreads would likely be 15 basis points to 20 basis points wider than they are now. If investors become less enamored of safety, mortgage yields could rise a bit, even if the 10-year Treasury, which helps determine mortgage rates, stays unchanged.

Of course, if now isn't a good time to own mortgage bonds, then

it is a good time to refinance a mortgage.


Agencies like

Freddie Mac



Fannie Mae


and the Federal Home Loan Bank also issue straight debt to finance their mortgage holdings. Spreads on agencies relative to Treasuries, like other sectors, are historically wide. However, a portfolio of Treasuries, corporates and munis will probably outperform agencies over the long term.

I'd recommend agencies under only two scenarios: as a higher-yielding alternative for someone who owns only Treasuries and who is uncomfortable with corporates; and as an alternative for someone who owns a lot of mortgage-backed bonds. (Diversifying into agencies can help maintain yield while reducing prepayment risk.)

It's been a strange year for the bond market. Some thought and planning will help you set up your portfolio for a successful 2002.

Click here to return to Part 1.

Brian Reynolds is a Chartered Financial Analyst who spent more than 16 years as a fixed-income portfolio manager and economist at David L. Babson & Co. in Cambridge, Mass. He currently writes and lectures about investment issues and trades for his own account. At the time of publication, he had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell. He welcomes feedback at

Brian Reynolds.