Bonds aren't always boring! New opportunities in an often-misunderstood asset class By Ernie Ankrim, Ph.D., Chief Investment Strategist Russell Investments June 3, 2008 My colleagues on the fixed team here at Russell bristle when equity folks say that bonds are boring. I understand their pain—especially with equity prices bouncing back nicely. From March 17 to May 14, the Russell 1000® was up over 11%, including dividends. The Russell 2000® returned about 13%. So yes, investors should pay attention to equities. But something unusual is happening in the bond market. Bonds, we know, are historically much less volatile than stocks. After all, if the stock market is like a rollercoaster, the bond market more resembles a merry-go-round. Bond volatility has been less frequent and less severe. That being said, the bond market now offers some exciting opportunities. So I chatted with Mike Ruff, Global Fixed Income Portfolio Manager at Russell. What Mike has to say is worthy of your attention. ERNIE: Why talk about bonds with equities bouncing back? MIKE: Let's start with a fundamental issue: most investors need to be diversified. So when investors think bonds, they think Treasuries. But corporate bonds offer the possibility of providing both higher yields and better opportunities for price appreciation. However, historically, corporate bonds have been viewed as the more risky investments because of the possibility that the corporation could default. ERNIE: So corporate bonds are pretty exciting right, relatively speaking? MIKE: We're seeing a significant increase in spreads through the first quarter of 2008, particularly in Baa-rated bonds. They have the lowest investment-grade bond rating and are adequate for municipalities and institutions required to hold investment-rated bonds in their portfolios. ERNIE: What do these spreads tell us? MIKE: They tell us that the market requires a much larger return than normal to accept the greater chance of default that exists in Baa corporates. However, we believe the current environment is over-estimating this risk and thus Baa-rated bonds may offer some tremendous opportunities. There are cases in which these spreads are justified—when a corporation's financial conditions or business prospects are weak. In some cases though, all Baa bonds get painted with the same "risk-perception brush", and in those cases the return possibilities are more than generous. We think that's what's going on now in many cases. Clearly, there still exists some concern about default rates in these bonds. But we think the current (near record) yield advantage Baa corporate bonds have over Treasuries represent return opportunities for Russell's fixed income funds. Of course, as with any increase in risk, the greater exposure could lead to lower returns if default rates are also record breaking, but for most of our managers they believe the possible rewards are a generous reward for accepting this risk. ERNIE: How unique are these sizeable spreads? Stearns' demise and questions about the viability of the financial system are the major reasons. Forced liquidations in hedge funds played a role, too. What's so special about today? Over the past 28 years during which we've gathered statistics, the spread has varied from below 1.00% (100 basis points) to above 2.50% with Baa-rated bonds always paying more than Treasuries. The average spread is about 1.58%. But as of March 31, 2008, the spread was 3.08%—the third-highest spread during this period. As of April 30, the spread went down to 2.67, but as I mentioned earlier, with yields down, bond prices went up. The highest spread in the last 28 years between Baa-rated corporate-bond rates and Treasury-rates was 3.33% in August 1986. A high spread reflects compensation for risk. SOURCE: Lehman Baa YTW - U.S. 10 Year SOURCE: Lehman Baa YTW - U.S. 10 Year Something else that's intriguing: Look at the yield in August 1986. Bond rates were far higher than they are today. Treasury rates were 6.59% while corporate Baa rates were 10.28%, a spread of 333 bps—the highest ever. But the spread of 3.08% this March is more impressive because it comes off a dramatically lower base. At the end of March 2008, Treasury yields were 3.45% and Baa yields 6.53%—almost double! ERNIE: There's still a lot of uncertainty regarding the economy. Is this really a good time to get into Baa-rated bonds? MIKE: Nervous investors seek safety in Treasuries. But historically, when consumers are least confident, investment opportunities appear most lucrative. People avoid risk, so the reward potential grows. That's why Warren Buffet says, "I want to buy when people desperately want to sell to me." Eventually, investors see that the world's not falling apart. ERNIE: So do bonds function principally as income generating vehicles or as trade opportunities? MIKE: Obviously, they're both, and that's the way they need to be seen. Some investors look at the dividend on a stock—the equivalent of yield—but mainly concern themselves with price. On the other hand, many investors often don't concern themselves with bond prices. But they're part of the equation, and rising bond prices offer real opportunities. ERNIE: So what should investors be thinking now? MIKE: Well, we certainly don't recommend that investors sell all their equities to buy Baa-rated bonds. But in a broader portfolio context, you're trying to find diversified sources of return. At Russell, however, we look at bonds not as income generating vehicles—though this factor is important to total return. We look at price appreciation with relatively stable bonds. ERNIE: Can you explain how Russell builds bonds into clients' portfolios? MIKE: Certainly. Russell's multi-strategy portfolios allocate assets to different sectors, and within the fixed income allocation, Baa-rated bonds are included as well as mortgage-backed securities where we also think there's a valuation disconnect. ERNIE: Just how enthusiastic are you? MIKE: Well, we don't want to get carried away. We're cautious, and we should be. But we think the economy will be okay—certainly not as bad as people thought some months ago. True, there are unknowns ahead. The key—and this really is always the case—is to stay diversified, manage risks and not over-extend. I do have to say that right now, we believe corporate bonds represent a good tactical investment. That's Mike Ruff's take on bonds, which actually can seem exciting. It's too bad that this asset class gets relatively short shrift, but a lack of heroically high returns relative to equities translates to a lack of major disasters. "Boring" like beauty is in the eye of the beholder. Bonds can be beautiful—as can a good night's sleep. Fund objectives, risks, charges and expenses should be carefully considered before investing. For a prospectus containing this and other important information call Russell at 1-866-676-7680 or go to the prospectus and reports page to download one. Please read the prospectus carefully before investing. These views are subject to change at any time based upon market or other conditions and are current As of May 29, 2008. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis, and opinions expressed herein are for general information only and are not Intended to provide specific advice or recommendations for any individual or entity. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Prices of fixed-income securities rise and fall in response to interest rate changes. Generally, when interest rates rise, prices of fixed-income securities fall. Expectations of higher inflation generally cause interest rates to rise. The longer the duration of the security, the more sensitive the security is to this risk. Lower-rated bonds, and bonds with longer final maturities, generally have higher credit risks. Bonds guaranteed by a government are subject to inflation risk and price depreciation risk. Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield ("junk") bonds or mortgage-backed securities, especially mortgage-backed securities with exposure to subprime mortgages. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® Index, representative of the U.S. large capitalization securities market. Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, representative of the U.S. small capitalization securities market. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Copyright© Russell Investments 2008. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. Securities products and services offered through Russell Financial Services, Inc. (formerly Russell Fund Distributors, Inc.), member FINRA, part of Russell Investments. For information on the Financial Industry Regulatory Authority, go to www.finra.org. RFD-08-0503. USI-0748. First used: June 2008			Subscribe to our Education Center RSS Learn more about using and subscribing to RSS   Comment on this Perspective What is your impression of Ernie Ankrim's insights? Provide your feedback.   Why Russell? See the difference Russell's investment approach can make   Printer friendly version of this page Send feedback or comments Site Search

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