by Michael Materasso, Fiduciary Trust International
Financial Times (U.S. Edition)July 28, 2003

The last three years have been spectacular for investors in US Treasury bonds. With interest rates near 45-year lows, investors have reaped double-digit returns, making Treasuries a "haven" during one of the worst bear markets for stocks in decades.

But for investors eyeing the future, the market for Treasury bonds now looks grim compared with other sectors of the fixed-income markets. There appear to be far more promising prospects in the "spread" sectors of the bond market, which include a wide range of corporate and government bonds around the globe that have higher yields than Treasuries. Typically, such securities are issued by almost anyone other than the US Treasury Department and pay a higher yield because of the varying degrees of risk. Investments in corporate bonds in the US and Europe, along with mortgage securities and emerging market debt, fall into this group and these all appear set to outperform Treasuries over the next few years.

Why is this the case? Since the Iraq war, the US economy has shown signs of recovery and an improving economy puts wind at the back of equity markets. Rising stock market capitalization provides a cushion for investors in US corporate bonds.

At the same time, the US is cutting taxes to lift the economy while boosting spending to pay for stronger national defense. This double whammy raises the specter of higher budget deficits, which in turn sets the stage for rising Treasury rates over the next few years as the government pays higher yields to attract investors.

This scenario differs greatly from the picture of the last five years. As the stock market and the economy suffered, investment grade and high-yield corporate bonds were battered by weakening credit quality and spectacular defaults in companies such as Enron and WorldCom. In emerging markets, investors suffered from crises in Argentina and Brazil. The under-performance of these spread sectors compared with Treasuries was dramatic. US high-yield issues, for example, lost a cumulative 45 per cent compared with Treasuries during the five-year period to the end of 2002, according to Lehman Brothers.

But now the direction of fixed-income markets looks sharply different. The brightest prospect may be the high-yield sector junk bonds. According to Moody's, the default rate of speculative bonds peaked last summer at close to 12 per cent and has been dropping steadily since. Many large firms that fell into junk bond territory are restoring themselves as solid credits. Examples include auto parts supplier Dana Corporation and packaging producer Owens Illinois.

The improvement in balance sheets is also helping investment-grade corporate bonds. Last year, valuations neared an all-time bottom in terms of spread over Treasuries when they reached close to 250 basis points against a 15-year average spread of 100 basis points, according to Lehman Brothers. But corporate Treasuries have been recovering since then and should keep rising. One reason: corporate managements are focused on improving balance sheets because equity markets are demanding it. What's more, federal regulators are forcing corporate managements to clean up their books. And healthier balance sheets should allow company fundamentals to continue to improve, regardless of whether the US economy grows 1 per cent or 3 per cent.

Selected European corporate non-dollar bonds also represent an opportunity, particularly for US investors. With the Federal Funds rate at 1 per cent, the Federal Reserve has little room for further rate cuts but European authorities are engaged in monetary easing. Falling European rates, with the prospect of continued pressure on the dollar, translates into potential capital and currency gains for US investors holding non-dollar bonds.

Emerging market debt is also an attractive asset class. Despite periodic newspaper headlines about frozen bank accounts, supermarket riots and currency crises, emerging market debt investments can be diversified among some 60 countries issuing bonds. Although this asset class does have heightened risk, such as currency and market volatility and political and social instability, on a risk-adjusted basis emerging market debt has compared favorably with many other leading asset classes, including US stocks.

That said, it remains a bond picker's market.

Investors will be better off staying diversified and targeting individual credits. There is substantial risk in individual companies and individual countries, making it essential to assess carefully the risks, economic or political, of any single holding. But a selective investor should be able to find opportune investments.

Michael Materasso is executive vice-president and global head of fixed income at Fiduciary Trust Company International, a member of Franklin Templeton Investments

This article appeared in the Financial Times (U.S. version) on July 28, 2003. To access the Financial Times online, visit their website at FT.com.

The Financial Times is not affiliated with Franklin Templeton Investments or FTI Institutional.

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