The best bond bargains for the year ahead? Corporates and mortgage-backed securties, Wall Street's debt analysts say.
``Unless interest rates move more than 150 basis points [1 percent] over the next six months, the risk/rewards of mortgage-backed securities are very favorable compared to Treasuries,'' says Gary Latainer, vice-president of fixed-income research at Morgan Stanley & Co., a New York brokerage firm.
A Ginnie Mae (Government National Mortgage Association) certificate now yields about 8 percent, compared with a 7.1 percent yield on a five- to seven-year Treasury bond. ``Even if Treasury rates dropped below 6 percent, a Ginnie Mae 8 would outperform it,'' Mr. Latainer says. ``That's a significant drop in rates. And Treasury rates could rise well into the 8 percent range before you'd outperform the Ginnie Mae on the other side.''
Ginnie Maes are shares in a pool of home mortgages. The shares are sold in $25,000 units. The federal government guarantees them against default but not against untimely interest and principal payments. Individuals can diversify their risk in Ginnie Mae mutual funds that start at about $1,000. The risk: It interest rates drop (as they have been doing), homeowners may rush to refinance their mortgages. Ginnie Mae yields will tumble. But Latainer figures the added yield compensates investors for that prepayment risk.
How great is the interest-rate risk now?
``I don't think the outlook for rates is sufficiently favorable or unfavorable to be the driving force'' in bond selections, says William McElroy, manager of Axe-Houghton Income, a highly rated mutual fund.
A recent survey of 51 economists tends to confirm Mr. McElroy's opinion. The consensus is that AAA-rated corporate securities will drop from an average yield of 9 percent in 1986 to 8.7 percent in 1987. (Currently, these yields are slightly lower than 9 percent.)
Three-month Treasuries are expected to slip from 6 percent to 5.4 percent on averge next year. The survey, done earlier this month by Blue Chip Economic Indicators in Sedona, Ariz., also notes that rates are expected to dip early in the year and rise toward year-end.
If you disagree with the consensus and believe a rapid business recovery coupled with a high rate of inflation lies ahead, McElroy advises investors to turn to stocks, not bonds.
But he favors the sluggish-growth, low-inflation scenario and is sticking with bonds - particularly corporate bonds. Corporate bonds sized up
``You can get another 140 basis points [1.4 percent] with an AA telephone bond or 200 basis points with a BBB utility. It's not the highest ever, but that's a relatively attractive spread,'' McElroy notes.
Yields on 30-year Treasury bonds weigh in at about 7.8 percent.
Virginia Electric recently sold a 30-year bond with a 9.27 percent yield. Louisiana Power & Light recently sold a BBB-rated 30-year bond with a 10.5 percent yield.
For more risk-oriented investors, even better returns can be had from oil companies, electric utilities with a nuclear exposure, and some money-center banks.
But Morgan Stanley's manager of credit research, Martin S. Fridson, advises investors to focus on higher-quality debt in a weak economy. He suggests that they ``keep a full or greater than market weighting in electric utilities and Telephone bonds,'' since cash flows are improving as firms move beyond the plant construction phase.
Mr. Fridson counsels against too much exposure to industrial bonds. ``If you've got 30 percent of your bond portfolio in industrials, go to 15 percent. The hazard of takeovers has created greater risk in this sector,'' he says.
A number of highly rated industrial bonds, such as Colt Industries, have plummeted in value as a result of takeovers, restructurings, or leveraged buyouts. Credit rating agencies downgrade these bonds, since mergers or restructuring actions often load the company with more debt, favoring stockholders over bondholders.
Some analysts say merger mania is being driven by the pending change in tax law. They believe takeovers will subside year year. But Fridson disagrees. ``It's an exaggeration to say all merger activity is motivated by tax code changes. The underlying trends of deregulation and consolidation of industries susceptible to world competition, for example, will remain in place.''
At the earliest, the government's laissez faire attitude toward mergers won't change until 1989, says Fridson, when a new administration may come into office. Junk bonds still attractive
Investors continue to find the hefty (11 to 13 percent) yields on junk bonds attractive. In the last two years, the amount of money in junk bond mutual funds has tripled. But if you buy into a sluggish economy, you must also accept that junk bonds may become even more risky.
Already, the default rate in 1986 has risen to about 3 percent. That's double the 1.5 percent average over the previous 11-year period. Also, it should be noted that while yields were higher in junk bond funds this year, better total returns (price appreciation plus yield) were found, on average, from less-risky bond funds.
But interest rates don't tend to drop that precipitously year after year. Proponents of junk bonds say that over a five-year period, they have consistently outperformed lower-yielding bonds. Others contend that a recession could bring on more defaults, possibly a financial collapse, leaving junk bond holders in the lurch. Municipal bonds clouded
The outlook for the tax-free municipal bond market has been clouded by tax reform. Some analysts say the market will be bolstered significantly by investors losing other tax shelters. But others argue that with individual tax rates dropping, fewer people will find the municipals' tax benefits sufficient to compensate for the lower yields.
``As my clients get close to the 33 percent top bracket, we're looking to '88, when they'll drop below 33 percent, says Claire Longden, a financial consultant at Butcher & Singer, a Philadelphia-based brokerage firm. ``They might not need municipals. They may get better returns in taxables.''
A Smith Barney, Harris Upham & Co. analyst, George D. Friedland, says municipal yields now are ``attractive but not spectacular.'' He says an A-rated municipal utility bond yields 7.4 percent. A comparble A-rated taxable industrial provides 9.5 percent. And compared with long-term governments, municipal yields are nearly at historical levels.
After this year's rush to finance projects before the tax bill went through, the supply of new bonds has dwindled. Mr. Friedland doesn't expect it to rise much in 1987.
``There's not enough supply or yields to satisfy people,'' he says. ``Frankly, I think a lot of money will find its way into the equity market next year.''