Sizing up the U.S. bond market, pre-debt ceiling

NEW YORK Wed Jan 9, 2013 2:14pm EST

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NEW YORK (Reuters) - Even with historically low bond yields furthering talk of a "bond bubble," 2013 may not be the time to abandon the Treasury market.

Despite the recent jump in the 10-year Treasury yield to 1.90 percent from 1.70 percent after the minutes from the latest Federal Reserve meeting spurred a sell-off in U.S. government bonds on hints that the Fed could pare its asset purchases by the end of the year, investor demand for U.S. debt should remain strong throughout the year, fund managers and analysts say.

The U.S. government is expected to reach its borrowing limit by March, something that would threaten a U.S. debt default if Congress does not act to raise the debt ceiling. A similar standoff in the summer of 2011 led to one of the most volatile weeks in stock market history and a rush into the safety of U.S. Treasuries. A flare-up in Europe's lingering fiscal problems would likely also spur a safety bid for U.S. government debt. The Federal Reserve, meanwhile, is expected to keep the federal funds rate near zero, keeping a lid on interest rates.

"You can't get a Treasury yield of 3 percent with a federal funds rate at zero. It's just not going to happen," said Jim Kochan, chief fixed income strategist at Wells Fargo Funds Management. Treasury yields for the 10-year note should stay below 2 percent for the rest of the year, he said.

But even if it makes sense to hold Treasuries, the current yield of 1.85 percent for 10-year notes won't do income investors much good. Fund managers are instead turning to municipal bonds and emerging market debt for yield, and moving into shorter duration securities to hedge against a possible rise in interest rates.

A classic favorite of many retail investors has long been the PIMCO Total Return Fund, the bond fund run by Bill Gross. But on Wednesday one strategist, Steven Goldberg, of Tweddell Goldberg Investment Management, told Reuters Insider that the fund is too big to succeed.

PIMCO Total Return, which ranks as the world's biggest bond fund with $285 billion in assets, earned a return of 10.36 percent in 2012.

YIELD PLAYS

Washington's deal to avert the fiscal cliff increased income taxes on individuals earning more than $400,000 a year, a boon for municipal bonds regardless of the debt ceiling debate. With higher income-tax rates, investor demand will pick up for tax-advantaged bonds issued in large states like New York, California and Texas, said Jim Sarni, managing principal at Payden & Rygel.

Municipal bonds should also benefit from scant supply of new bonds. The total size of municipal debt issuance is expected to stay steady at close to $400 billion in 2013, according to estimates from Wells Fargo and Bank of America Merrill Lynch, providing support for existing bond issues, even after the Barclays Municipal Bond index returned nearly 6.8 percent in 2012.

The tax advantages of municipal bonds depend on where an investor lives. California residents, for example, should opt for a fund like the $423 million T. Rowe Price California Tax-Free Bond fund, which yields 3.9 percent, while New Yorkers should consider the $458 million T. Rowe Price NY Tax-Free bond fund, which yields 3.6 percent. Funds provide a hedge against the risk of a municipal bankruptcy or default an individual security might bring.

Other fund managers are looking abroad for yield. Don Quigley, portfolio manager of the $2 billion dollar Artio Total Return Bond fund, is focusing on government debt issued by Canada, Australia, Mexico and Brazil. These four countries offer a combination of better yields and stronger fundamentals than comparable U.S. government bonds, he said.

The 10-year Canadian bond, for instance, yields 1.92 percent, compared with a 1.87 percent yield for the comparable Treasury note. Brazil, meanwhile, has a 10-year yield of 9.33 percent. For his Brazil position, Quigley is focusing on shorter durations, which allows him to benefit from both the country's appreciating currency compared with the dollar and from the bond yields themselves, he said. Brazil's fundamentals, like a low unemployment rate and the largest economy in Latin America, also make it attractive, he said.

One popular fund option: the $7.9 billion PIMCO Emerging Markets bond fund, which yields 4.3 percent and costs $1.25 per $100 invested. The fund, which holds a mix of dollar-denominated corporate and government debt, is one of the least volatile funds among its peer group and emphasizes countries with improving credit fundamentals, noted Miriam Sjoblom, an analyst at Morningstar. Its top holdings include securities issued by Russia, Bolivia and Venezuela.

SHORTER DURATIONS

Despite the concerns about the debt ceiling, some investors are prepping for an improving economy by buying shorter-duration corporate debt and shying away from exotic yield plays.

"The Fed is forcing investors out of U.S. Treasuries with record low interest rates and into sectors they would not normally invest in," said Jason Weiner, portfolio manager of the $578 million BMO Aggregate Bond fund.

Once the debt ceiling showdown is over, Weiner plans to trim his junk bond positions to focus on investment-grade corporate bonds with one- to three-year durations. Shorter durations should provide a cushion if interest rates - and the economy - strengthen further as the housing market continues to improve, he said.

Yet he acknowledges that it's a wait-and-see approach. "Ultimately, we won't know if the economy can adjust to higher taxes until the second half of the year," he said.

(Reporting By David Randall; Editing by Lauren Young, Jennifer Merritt and Leslie Adler)

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