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
It's essential to keep the rates on benchmark U.S. Treasury bonds under surveillance. Corporate issues are generally priced at a spread to a Treasury rate with a similar maturity, based on the issuer's credit rating.

Clues to the market
The broad credit market is influenced by a host of macroeconomic factors. Last week, prices of longer-dated Treasuries fell, as speculation of a rate cut diminished because of strong economic data and comments given by Fed Chief Ben Bernanke. For the week, the two-year note yield declined three basis points, while the benchmark 10-year yield rose three basis points, and the 30-year yield increased by four basis points. Bond prices move inversely to yields.

A surprisingly steep drop in new home sales led to a climb in Treasuries on Monday. Bond prices recaptured ground lost the previous week as two-year yields declined three basis points and 10-year yields slipped two.

Treasuries then reversed course and fell the next three days. Prices slipped on Tuesday as hawkish Fed chatter depressed speculation about future rate cuts. On Wednesday, prices declined primarily in the long end of the yield curve following Bernanke's testimony to Congress and an uninspiring two-year note auction. While Bernanke's written testimony contained no surprises, he emphasized an inflationary focus. The two-year remained flat, while the 10-year yield rose to 4.62% and the 30-year climbed to 4.83%. The sell-off continued on Thursday amid another lackluster Treasury auction, along with strong readings on economic growth and the labor market. The 10-year added two basis points to its yield, while the two-year note yield increased by four.

Volatile trading marked Friday's session. Strong economic reports initially caused selling, while reports that American citizens were advised to leave Bahrain and the U.S. announcement of sanctions against paper imports from China stimulated buying. Ultimately, Treasuries closed the day largely unchanged.

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

• Morgan Stanley (NYSE:MS) began selling $2.5 billion worth of loans of New Century Financial, previously held as collateral.
• PIMCO chief investment officer Bill Gross said he expects the housing market to see tighter lending conditions for years to come as a result of the subprime sector woes.
• Credit spreads associated with Beazer Homes (NYSE:BZH) widened following the company's announcement late Wednesday of a federal probe into its mortgage business.
• The U.S. Treasury sold: $18 billion two-year notes on Wednesday at a lower-than-expected yield of 4.514%, in an auction which saw less demand from foreign purchasers; and $13 billion five-year notes on Thursday at a higher-than-expected yield of 4.535%, in an auction characterized by little investor demand overall.
• Moody's announced that it will revise its much-criticized methodology for rating banks by lowering the weight it has previously accorded outside support.
• Wal-Mart (NYSE:WMT) issued a three-tranche $2.25 billion offering, larger than its original plans to sell $2 billion.

Hot tip
For investors looking to buy and hold decent-quality corporate bonds, it's becoming a buyer's market for those willing able to stomach some risk. But if you're looking for short-term trading profits, stay away.

Spreads, which measure the extra yield that corporate bonds carry over comparable Treasuries, have widened over recent weeks because of worries over the potential subprime fallout and a slowing economy. Any further weakening in the overall economy, as alluded to by former Fed head Greenspan, will further increase risk premiums.

Corporations are still enjoying lower borrowing costs. The recent equity tumble spurred a flight to quality, pushing down Treasury yields. Corporate bond issuance remains strong, and while spreads have widened, they remain relatively narrow in a historical context. If spreads were to widen drastically, or pronounced equity weakness or liquidity problems were to ensue, then the potential default risk would be too high. As it looks now, this may be the right time to investigate specific corporate bond issues for your portfolio.

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 but doesn't own shares of the companies mentioned in this article. She prefers her portfolio shaken, not stirred. The Fool has an ironclad disclosure policy. Wal-Mart is an Inside Value pick.