Bonds Head for Big Trouble?

Taking a chance in the bond market today is like trying to win a reality television contest. The odds are hugely against you -- and you're likely to end up humiliated, defeated and, in the case of the bond market, poorer.

Prices are exorbitant for almost everything in fixed-income-land, except Treasuries and high-quality munis. High-yield bonds are especially dear, even after selling off over the past seven weeks. I fear that investors will soon discover why high-yield IOUs are usually called junk bonds.

Companies don't issue bonds with super-high yields because they're feeling generous. They do it because there's a real risk that they'll go bankrupt, and investors demand high yields to compensate for that risk.

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But junk-bond yields are puny today. They are a mere 3.4 percentage points higher than Treasury yields. That's up from 2.4 percentage points since June 5, when the junk market began to sour. The 2.4 percentage points was the lowest difference in yields -- known as the spread in bond talk -- in at least a decade. Spreads between junk and Treasuries have been as high as 10.6 percentage points and have averaged 5.4 percentage points during the past decade. So these yields still have much higher to go.

Emerging-markets debt could well become part of the collapse. Yields are a tiny 2.2 percentage points higher than Treasury yields, compared with an average spread of 5.9 percentage points and a high of 14.8 percentage points over the past decade. Emerging markets are stronger financially than they used to be, but they aren't that strong.

What's an investor to do? Loomis Sayles Bond (symbol LSBRX), my favorite taxable bond fund for long-term investors and a member of the Kiplinger 25, has an average credit quality of single A. "That's about the highest we've ever been," says Kathleen Gaffney, who signed on as co-manager in 1997. Senior manager Dan Fuss has been with the fund since its inception, in 1991.

Gaffney and Fuss are worried about the higher-risk segments of the bond market. "Spreads are still tight," she says. "But I think the housing downturn will be pretty protracted, and I think it'll cause more pain to consumers." Because spending by consumers represents two-thirds of the U.S. economy, Gaffney sees a lot of risk, particularly for investors, such as hedge funds, that have borrowed heavily to magnify bets on risky bonds. "We've been to this show before," she says.

At the same time, more types of obligations have been "securitized" -- that is packaged and resold as debt obligations to investors -- than ever in history. Nowadays, institutions and sophisticated individual investors trade debt instruments based on everything from corporate accounts-receivable to subprime mortgages to unpaid credit card debts. "There's no pricing transparency," Gaffney complains. Translation: It's incredibly hard to tell what any of this stuff is worth.

Gaffney is eagerly anticipating a deeper plunge in low-quality, fixed-income securities: "I want to have fun. They keep teasing us. We get these little cracks in the market, and then nothing happens. But we will be ready when it does happen."

Among tamer fare, Gaffney isn't finding bargains in Treasury Inflation-Protected Securities, either. She thinks inflation is already well priced into the bond market.

Nor does she like convertible securities -- a kind of half-bond, half stock hybrid security. Although they are less risky than stocks (see Get a Smoother Ride With Convertibles), convertibles have been attacked by fast-trading hedge funds. "The hedge funds have taken the value out of that market," Gaffney says.

Still, Loomis Sayles Bond doesn't hold much cash. That means its managers are putting the fund's money to work. Gaffney and Fuss believe the yields on ten-year Treasury notes won't go much beyond 5% during the current economic cycle. "We think the housing downturn will pull rates lower." (The ten-year note closed at 5.0% on July 23.)

Consequently, the fund has lengthened the maturity of its average bond from a record low of eight years a couple of years ago to 15 years today. That's still shorter than the fund has been historically, but it's aggressive compared with most bond funds.

The U.S. economic outlook for the next several years isn't as bright as the outlook in most foreign countries, especially emerging markets, Gaffney says. And the U.S. is laboring under a massive budget deficit. As a result, Gaffney thinks the dollar will continue to decline. "We see weaker growth in the U.S., and stronger growth overseas."

The fund has one-third of its assets in foreign currencies. "The dollar is in for further weakness," Gaffney predicts. (If the dollar weakens, fund assets denominated in euros, yen, pounds and other currencies will appreciate.)

Over the years, I've found that the insights provided by Fuss and Gaffney have often proven valuable for stock investors. So if Gaffney is right on the dollar, and I think she is, that means foreign stocks will continue to benefit from stronger growth and a declining dollar.

Along the same lines, stock investors should note that the pair also remain bullish on energy. "Energy is a good inflation hedge, and I think prices are headed higher for a while," Gaffney says.

Before you rush out and buy this fund, please be aware of how risky it is. Even now, Gaffney and Fuss have 23% of assets in junk and the same percentage in BBB bonds, which are near the bottom of the investment-grade ranking ladder. I trust their bond-picking acumen. Nevertheless, this isn't a fund for short-term investors or for the faint of heart. Another negative: Annual expenses are high at 1%.

But long-term investors have been rewarded handsomely. Since inception, the fund has returned an annualized 11% through July 23. Over the past ten years, it has returned an annualized 9% -- an average of three percentage points per year more than the return of Lehman Brothers Aggregate Bond Index.

Don't expect returns that high going forward. After all, bond yields simply aren't high enough to provide those kind of rewards in the next ten years. But Loomis Sayles Bond is still a terrific fund. If you're investing in a taxable account, though, stick to a good, high-quality intermediate muni fund, such as Vanguard Intermediate Term Tax Exempt (VWITX) or Fidelity Intermediate Municipal Income (FLTMX; a member of the Kiplinger 25).

Steven T. Goldberg (bio) is an investment adviser and freelance writer.