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.

Clues to the market
The broad credit market is influenced by a host of macroeconomic factors. Treasury prices moved higher last week, while the market focused on subprime credit concerns of ratings agencies. For the week, the two-year note yield fell six basis points to 4.91%, while the 10-year yield dropped nine basis points to 5.10%, and the 30-year yield slipped three basis points to 5.19%. Bond prices move inversely to yields.

A relief rally took place on Monday as bargain hunters took advantage of yields at two-week highs. The 10-year yield dropped four basis points to 5.15%. The buying continued on Tuesday, fueled by subprime concerns and disappointing retail earnings projections. Both Standard & Poor's and Moody's warned or downgraded subprime mortgages, and Treasury yields posted their largest declines in more than four months. The 10-year yield dropped to 5.03%, while the two-year fell nine basis points to 4.85%.

Any further flight to quality flew out the window the remainder of the week. On Wednesday, the market shifted course and prices fell for the first time in three days. Higher equities, as well as comments from the president of the Philly Fed that economic prospects remain good, pressured bonds and sent the 10-year yield up to 5.09%. Continued equity strength and record highs on Thursday meant more losses for bonds. The 10-year yield advanced to 5.13%, and the two-year yield registered 4.93%. Treasuries gained slightly on Friday after initial strength from a weak retail sales report was pared by a high consumer confidence report.

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

• The U.S. Treasury sold $8 billion in 10-year TIPS on Thursday at a higher-than-expected 2.749% yield, indicating that 2.38% is the anticipated average inflation rate forecast over the life of the notes.

• According to a report in The Wall Street Journal, contributions to money-market fund assets totaled $20.62 billion for the week ended Tuesday, setting a fresh record for the second consecutive week.

• Dura Automotive Systems filed a bankruptcy reorganization plan which would not pay anything to investors holding $560.7 million of subordinated bonds.

• Moody's issued a critical report of buyout firms, questioning their short-term outlook. Separately, the company lowered its ratings for 399 residential mortgage-backed securities and stated that it may cut ratings of $5 billion collateralized debt obligations.

• Standard & Poor's announced it may cut the ratings on $12 billion of bonds backed by subprime mortgages, news of which sparked a flight to quality and dumping of the securities on Tuesday. On Thursday, the agency corrected the volume of such bonds and restated the total as $7.35 billion.  

• An SEC official told Congress that Bear Stearns (NYSE: BSC) will likely be able to sell assets at its two troubled hedge funds in an orderly fashion with limited impact on the broader market.

• Corporate bond risk rose during the week to the highest level in almost two years, led by concerns over homebuilder and financial services bonds.

• Companies issuing debt in the public market included:

            American Capital Strategies, which sold $500 million in five-year notes;

            Commercial Metals, which sold $400 million in 10-year notes;

            Fannie Mae (NYSE: FNM), which sold $1 billion in 10-year notes in a reopening for a 5.531% stop-out rate, and $4 billion in two-year notes at a 5.173% yield;

            Georgia Power, a unit of Southern Co., which sold $300 million in 40-year senior notes, increased from the anticipated $150 million;

            John Deere Capital, a unit of Deere (NYSE: DE), which sold $400 million in three-year floating-rate notes;

            Lehman Brothers (NYSE: LEH), which sold $5 billion in debt in a three-tranche offering consisting of five-year, 10-year, and 30-year securities;

            Limited Brands (NYSE: LTD), which sold $1 billion of debt in a two-tranche offering consisting of 10- and 30-year securities;

            PepsiAmericas, which sold $300 million in five-year notes;

            PPL Capital Funding, a subsidiary of PPL, which sold $100 million 40-year senior notes.

            Walt Disney (NYSE: DIS), which sold $1.1 billion in debt in a two-tranche offering of three- and 10-year securities, increased from $750 million;

            and XTO Energy (NYSE: XTO), which sold $1.25 billion in debt in a three-tranche offering of five, 10, and 30-year securities.

• No junk bonds were sold as Swift and Quebecor Media canceled offerings.

Hot tip
Agency mortgage bonds issued by Fannie Mae, Freddie Mac, and Ginnie Mae represent a $4 trillion market. According to recent data compiled by Lehman and reported by Bloomberg, agency mortgage bonds suffered their worst month in June in nearly four years and returned 0.53% less than comparable Treasuries.

Agency bonds are often thought of as a viable alternative to Treasuries in terms of safety, but there are some distinctions. Agency bonds carry an "AAA" credit rating and are guaranteed by the issuer. In the case of Ginnie Mae bonds, the securities are backed by the "full faith and credit of the U.S. government," like Treasuries. For Fannie- and Freddie-issued bonds, the securities carry the credit risk of the particular government-sponsored entity. The debt typically carries a premium over Treasury yields, which varies with market conditions.

Headlines blared last month about the troubles of two hedge funds managed by Bear Stearns that held subprime mortgage bonds and collateralized debt obligations. But the poor performance of agency bonds last month is thought to be less a direct reflection of credit quality concerns in agency bonds, and more a matter of simply being bested by Treasuries, which benefited from those worries. Demand for Treasuries picked up in June on a flight to quality from subprime concerns and global tensions, as well as volatile interest rates. Refinancing of adjustable-rate mortgages also created an upswing in supply of agency mortgage debt.

Given market conditions, it may not be surprising to see agency bonds continue to lag Treasuries. On the bright side, though, agency mortgage bonds outperformed corporate junk bonds, while carrying considerably less risk. If spreads widen, agency bonds may look more attractive to the investor seeking higher yields and relative safety. You may have to wait in line behind China, though. Just last week, the Bush administration made a pitch for investment in Ginnie Mae securities along these same lines to China's central bank.

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 a Motley Fool Inside Value recommendation. Disney and Moody's are Stock Advisor picks. American Capital Strategies and Limited Brands are Income Investor selections. She prefers her portfolio shaken, not stirred. The Fool has a disclosure policy.