How to Play Rising Rates

Marilyn Cohen, Forbes Magazine, 3.15.04

When the Fed tightens — and it will — don't bail out of bonds. There are still some wise moves to make. Think about ten-year Treasurys or junk on the mend.

Enjoy it while it lasts, bond investors. I mean the bull market for fixed income. With interest rates not far above the rock bottom, bond portfolios did fairly well last year. Junk bonds did particularly well (I turned bearish too early in my July 21, 2003 column). They benefited not only from low rates generally but also from the narrowing of yield spreads over Treasurys.

It won't last. Rates can't stay this low for much longer. A 1% Federal funds rate is too low for an economy growing at a 4% annual clip. And even before the Federal Reserve tightens, a new generation of bond vigilantes will begin work. Result: weak bond prices.

This gathering storm, however, doesn't mean you should abandon bonds. The best ones provide steady income and should be held to maturity. Your sole concern, other than avoiding those that might default, is if you have to sell your bonds before they are due.

Every bond portfolio should include Treasurys, since they enjoy zero default risk. But which ones? On the Treasury yield curve, the sweet spot, with the best yield for any given amount of principal risk, belongs to the ten-year Treasury, at 4%. The longest-term Treasury, maturing in 2031, yields a mere eight-tenths of a percentage point more than the ten-year issue. Those 17 extra years of exposure to possible rate rises are too much for the small increment in yield.

In junk the sweet spot is at the high end of the credit quality spectrum. Go for corporates that stand a good chance of getting an upgrade to investment quality (meaning BBB or better). Near this borderline between junk and investment grade you can pick up almost a three-point yield spread over Treasurys, meaning a ten-year corporate will yield close to 7%. Look for issuers with improving business performance and with balance sheets that have already benefited from lower rates.

A good example is Leucadia National, known as "the little Berkshire Hathaway" for its potpourri of businesses--banking, winemaking, insurance, mining. Run by the same consistent management team for years, profitable Leucadia has a long history of integrating new acquisitions. With an improving economy, earnings will continue to advance.

This borrower is right on the borderline, with a split rating: Moody's rates its bonds Ba1, or high-grade junk, while Standard & Poor's rates them BBB-, the lowest investment-grade rating. Two issues interest me, with 7.75% and 7.0% coupons both maturing Aug. 15, 2013. The 7s, issued last year, are priced at 103 to yield 6.6% to maturity. The 7.75s, issued in 1993, are priced at 106 to yield 6.9%. And get this: Both are noncallable. Despite Moody's rating, your principal is safe.

The Dennis Kozlowski trial, with its tales of chicanery and wretched excess, obscures the fact that his former company, Tyco International, is very solid. Tyco is another conglomerate (electronic components, undersea cable, medical supplies and more), and it, too, has a split rating: BBB- with a "stable outlook" from S&P; Ba2 from Moody's, with a "positive outlook," meaning an upgrade may well be in the offing. I like Tyco's 6.375s due Oct. 15, 2011, priced at 107.3 to yield 5.2%. This issue has the added virtue of being noncallable.

Since a lot can happen to a corporation (or to interest rates) in the space of 18 years, I prefer the 7-year bond to a 25-year sibling, the Tyco 6.875s due Jan. 15, 2029. This, despite the better than one point yield gain on the longer bond: It's priced at 104.5 to yield 6.5%. With the intermediate-term Tyco, moreover, you will soon enjoy an attractive "roll-down" effect, in which that 5.2% you are earning looks better and better. Four years from now you will be earning it on a 3-year bond, and 5.2% is terrific for 3-year bonds.

Longer maturities are, of course, much further from the point where the yield curve rolls down. There isn't much difference in yield between a 25-year bond and a 21-year bond. The longer bond, moreover, is exposed to more potential price risk in a period of rising rates. Say interest rates spike two percentage points by year-end 2006 across the yield curve. The Tyco bonds that cost you 107.3 will slump in price to 96.7 for a 10% principal loss. If you had bought the longer Tyco bond due in 2029, your bond price would have dropped to 84 for a 20% loss.

Bond investing is risky, even for nondefaulting issuers. Rates may rise; indeed, they are virtually certain to rise at least a little. But it is better to take a little risk to get a 4% to 7% return than cower in the money market with 1% and lose out to inflation and taxes.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at www.forbes.com/cohen.

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