Where to Invest Right Now: Bonds?

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Last month, Fed Chairman Ben Bernanke declared that the recession is most likely over. Of course, that proclamation by itself doesn't mean it's time to break out the bubbly. Despite signs of economic and financial stabilization, we're not out of the woods yet.

Investors need flexibility and liquidity in their portfolios. That means investing in stocks and bonds. So where do you begin to invest in the bond world? What areas offer the best return?

To get some answers, I spoke with some bond experts at Payden & Rygel Investment Management. Here's what they had to say.

What rates will do
Before you invest in bonds, you should have an idea of the direction in which interest rates are likely to move. According to Thomas Higgins, Payden's chief economist, the Fed is starting to phase out some of the unconventional programs it implemented at the height of the financial crisis. That in turn should lead to a tightening of policy.

Higgins believes interest rates will climb higher gradually. "The yield increases will be more steady, measured yield increases," Higgins said on a recent call. "Debt-to-GDP is expected to grow significantly and so rates could rise 120 to 150 basis points starting around the middle of next year. Though there is the risk that the Fed may act preemptively, especially if the strength of the U.S. economy surprises on the upside."

Where to invest in the bond universe now
With that background in mind, let's take a look at Payden's specific recommendations. The investment management company takes a three-pronged approach to bond investing right now, focusing on corporate bonds, municipal bonds, and emerging-markets debt to take advantage of the opportunities in fixed-income securities.

Corporate debt
Jim Sarni, managing principal and senior portfolio manager at Payden, likes both investment-grade bonds and high-yield junk bonds that have ratings below investment grade.

On the investment-grade side, Sarni favors companies in defensive industries. In particular, he notes that Allied Waste, which merged with Republic Services (NYSE: RSG  ) last year, offers six-to-seven-year bonds with yields above 6%. For those with a shorter time horizon, Sarni likes Dow Chemical (NYSE: DOW  ) , whose three-year bonds offer a yield between 3.5% and 4%.

For those seeking higher yields from riskier bonds, Sarni favors Georgia Pacific, whose seven-year bonds yield 7.5%. He also mentioned long-term bonds of Edison Mission Energy, owned by Edison International (NYSE: EIX  ) , which offer an 11% yield.

In addition, Sarni says Payden owns some bank names such as Bank of America (NYSE: BAC  ) , Wells Fargo (NYSE: WFC  ) , and JPMorgan Chase. "These offer slightly higher yields than other comparable maturity and quality issues due to the obvious concerns about the banking industry today," Sarni said.

Municipal bonds
Sarni expects to see higher income taxes, given the amount of debt the U.S. is undertaking. Municipal bonds can help investors fight the impact of higher taxes, because interest income from munis is generally exempt from tax both at the federal level and within the state in which the bonds are issued.

Although munis have already had a nice run, Sarni says they're still attractive at current valuations: Munis trade with yields around 4.5% to 5%. If the top tax bracket eventually approaches 50%, Sarni says, that would equate to taxable equivalent yields of 9% to 10%, which would provide nice capital appreciation for investors.

Emerging-markets debt
Just as stock investors have benefited greatly from investing in emerging-market companies like China's Baidu (Nasdaq: BIDU  ) and Brazil's Petroleo Brasileiro (NYSE: PBR  ) , bond investors can invest in emerging markets by buying government bonds from emerging-market countries. Payden recommends focusing on the high-quality end of this market. "The goal is to still get yield without sacrificing quality," said Kristin Ceva, principal and director of Payden's global fixed-income group. "It offers diversification. You get sovereign diversification and a different risk profile."

Ceva says the fundamentals for emerging markets are stronger than those for developed markets right now. Debt-to-gross domestic product levels, for instance, are more favorable in emerging markets, because in developed countries, fiscal deficits ballooned higher in the wake of the financial crisis. Ceva also says the geopolitical landscape has improved. In addition, Ceva says the International Monetary Fund acts as a good backstop, which acts as a type of insurance for investors.

According to Ceva, 50% of the emerging-markets debt sector now has an investment-grade rating, yet investors can get yields of 7% or more from emerging-markets debt versus just 5% from investment-grade corporate debt.

Ceva has an overweight rating on Latin America and Asia and an underweight rating on Eastern Europe. Within Asia, Ceva likes Indonesia and the Philippines. Within Latin America, she favors Brazil, Colombia, Panama, and Peru. In general, Ceva believes there's a lot of potential in emerging-market bonds. "Emerging markets will get higher growth rates than developed [markets] and we're already seeing this," Ceva said.

Going beyond stocks
To put together a complete portfolio, you need bonds as well as stocks. Paying closer attention to how you invest the bond portion of your portfolio can make just as big a difference as buying the best stocks.

Related Foolishness:

Fool contributor Jennifer Schonberger owns shares of Bank of America, but does not own shares of any of the other companies mentioned in this article. Baidu is a Motley Fool Rule Breakers pick. Petroleo Brasileiro and Republic Services are Income Investor selections. The Motley Fool has a disclosure policy.

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