Choosing High-Quality Bonds Key In Difficult Times

Choosing High-Quality Bonds Key In Difficult Times

BERLIN – High-quality bonds have become particularly attractive in recent months, especially as several factors continue to weigh on the market — from the crisis in the financial markets to recessionary pressures. What’s more, according to David Rosenberg, Chief North American Economist at Merrill Lynch, “The economic pressures we face today could stretch into the first half of next year.”

To chart a smart path through these challenging markets, where should investors focus their attention and assets? According to Martin Mauro, Fixed Income Strategist at Merrill Lynch, one answer is higher-quality investments — a category that can take in carefully selected equities, but should almost certainly include Treasuries and other high-quality bonds.

So where can risk-averse investors find quality investments that offer better yields? The current period may be a particularly opportune time to look to bonds. History can provide some context in this case: In 24 of the 81 calendar years since 1926, equities yielded negative returns. In contrast, investment-grade bonds generated positive returns in all but two of those negative years for equities. As the S&P 500 draws ever closer to a negative 2008, bonds may be the better investment again. Similarly, in contrast to the double-digit declines for stocks, the Merrill Lynch Master Domestic bond index has posted a 0.8% gain for 2008, through Sept. 15.

If you’re interested in bond investments, consider in particular the three that Mauro likes most under the present economic conditions:

(Treasuries and other high-quality bonds. Treasury securities offer the safest alternatives within the bond market. Investors who want to improve on the yield of Treasuries and who have a longer investment time frame should consider FDIC-insured CDs from quality banks or the senior debt obligations of Fannie Mae and Freddie Mac. Although these securities may have lower credit risk, investors should be aware that, as with all bonds, the price of these securities will decline if market yields rise. “Treasuries are one of the world’s best performing assets so far this year,” says Richard Bernstein, Chief Investment Strategist at Merrill Lynch. “Simply put, the world’s highest quality asset remains the world’s highest quality asset.”

Municipal bond prices have also declined amid the recent financial market turmoil. As a result, yields have risen to extraordinary levels in relation to yields on Treasury securities, offering an important investment opportunity. Normally, the yield on a 10-year AAA-rated general obligation bond is 85% to 90% of the yield on a Treasury security. Now municipal yields are meaningfully higher than yields on Treasury securities of the same maturity, even though interest income on municipal bonds is exempt from federal taxation. “State and local government budgets are no doubt going to feel the strains of recession,” says Mauro, “but a well-diversified portfolio of high-quality municipals should provide attractive after-returns over the next few years.”

Treasury inflation-protected securities, or TIPS, can help preserve purchasing power against inflation. Inflation will probably decline significantly in the coming months, but it would not take much inflation for TIPS to provide relatively good returns. As long as inflation is above 1.2% during the next five years (the Consumer Price Index rose by 5.4% for the 12 months ending this August), investors would receive a better return from a five-year TIP security than a nominal five-year Treasury, Mauro says.

To help you determine the role bonds should play in your investment strategy, speak with your financial advisor, who can help you evaluate your current asset allocation and find suitable investments for your liquid assets.

(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)