Investor 007's Bond Dossier

Meet Investor 007. His specialty? Bonds. Fixed-income bonds.

Don't be fooled by their low-profile reputation. Beneath that cunning disguise, bonds are sophisticated tools to help safeguard your portfolio from the perils of riskier investments. Here's the latest intelligence on their high-stakes world. If you're new to the game, get briefed on the basics of Investor 007's business, or check out our Bond Center for some useful gadgets to help ensure a successful investing mission.

Spying on rates
The benchmark U.S. Treasuries are key rates to keep under surveillance. Corporate issues are generally priced at a spread to a Treasury rate with a similar term, based on the issuer's credit rating.

U.S. Treasury

Price

Yield

Two-year

$99'25

4.97%

Five-year

$99'01

5.09%

10-year

$94'23

5.19%

30-year

$92'07

5.22%

Clues to the market
The broad credit market is influenced by a host of macroeconomic factors. Treasury prices fell during last week's shortened holiday trading. The benchmark 10-year note yield rose by the greatest amount in almost three months, as expectations dimmed for a Federal Reserve rate cut any time soon. For the week, the two-year note yield rose 10 basis points to 4.97%, while the 10-year yield increased 16 basis points to 5.19%, and the 30-year yield added 10 basis points to 5.22%. Bond prices move inversely to yields.

Treasuries began the week strongly, buoyed by continued subprime and terrorism concerns, even as the ISM manufacturing index came in better than expected. The 10-year yield fell 4 basis points to 4.99%, the first time the yield dropped below 5% in several weeks. On Tuesday, prices slipped in thin holiday trading during a shortened trading session. Economic reports included a strong factory-orders reading, offset by weak existing-home-sales data. The 10-year yield rose to 5.05%, while the two-year registered 4.89%.

Following the July 4 holiday, traders returned to send Treasuries to their largest losses in three weeks. Weakness in European and Asian government bonds, compounded by unexpected growth in the domestic-services sector, pushed the 10-year yield up 9 basis points to 5.14%. On Friday, the June employment report sent Treasury prices down further as wage growth fueled inflationary fears. The 10-year yield climbed another five basis points, to end the week at 5.19%, its highest rate in three weeks.

Detecting developments
Investor 007 noted the following occurrences in the bond market last week:

  • Treasuries outperformed mortgage-backed bonds guaranteed by Fannie Mae (NYSE: FNM  ) , Freddie Mac (NYSE: FRE  ) , and Ginnie Mae by 0.53% last month, the largest differential in almost four years.
  • Movie Gallery (Nasdaq: MOVI  ) stated that it failed to meet terms of its senior credit facility. It's in talks with lenders over a possible waiver or other solution.

Hot tip
Although Thomson Financial recently reported that U.S. high-grade and junk-bond issuance rose in the first half of the year, signs of a potential slowdown have emerged.

Several deals have encountered resistance over the past few weeks. Underwriters pulled a $1.55 billion bond offering by U.S. Foodservice, and the company's $2 billion loan sale was postponed. Catalyst Paper withdrew a $150 million bond offering that had already been downsized from $200 million, while CanWest MediaWorks lowered its own planned junk-bond offering from $650 million to $400 million, and private-equity firm Carlyle Group reduced the public offering of a mortgage bond fund.

Deal components have also come under scrutiny. Dollar General (NYSE: DG  ) restructured a $1.9 billion debt sale to finance its leveraged buyout offer by dropping a sale of "toggle" bonds, which allow borrowers to pay interest by issuing additional bonds in lieu of cash. Similarly, ServiceMaster (NYSE: SVM  ) postponed its $1.15 billion sale of junk bonds, which would have included toggle provisions.

Despite last week's holiday, takeover activity picked up again, easing concerns over market conditions. Still, it doesn't look as though the junk-bond environment will be as laissez-faire as it has been. Investors are becoming more wary. They're cutting riskier assets from their portfolios, and they aren't quite as willing to let issuers dictate terms. Don't be surprised to see yield differentials between Treasuries and junk bonds widen, and lesser-quality deals falter.

ServiceMaster is an Income Investor recommendation. Find out how combining bonds with dividend-paying stocks can be a winning combination for your portfolio with a 30-day free trial.

Fool contributor S.J. Caplan has been an undercover fixed-income aficionado ever since serving in banking and legal capacities covering debt underwriting as well as fixed-income derivatives. She owns U.S. Treasuries and shares of the Fidelity Inflation Protected Bond Fund. Fannie Mae is an Inside Value recommendation. She prefers her portfolio shaken, not stirred. The Fool has a disclosure policy.


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