10-1-13 3:12 PM EDT | Email Article

By Rachel Koning Beals


CHICAGO (MarketWatch) -- The Federal Reserve's eventual withdrawal as a big bond customer, and the expected price drop and interest-rate rise -- may finally bring the demise of a decades-long bond bull market that has used up nine lives and then some.


Yet few analysts expect a market-hobbling spike for rates and a bottoming out in bond prices, and third-quarter results for bond mutual funds and exchange-traded funds support that view.


Consider that taxable multisector bond funds scratched out a 1.1% average quarterly return, according to preliminary data from investment researcher Morningstar Inc.


Government-bond funds struggled, but corporate and emerging-market bond funds recorded respectable returns to salvage part of their tough year. Municipal bond funds were little changed in the quarter, although high-yield muni funds fell 2.4% on average.


With these returns, should investors shy away from bonds and bond funds as the Fed tinkers with interest-rate policy (or so far, teases more than tinkers)? Money managers and strategists seeking fixed-income solutions to round out portfolios aren't turned off. Instead, they're selective shoppers. Here are three ideas they're following:


1. Treasured Treasurys


There's no "Treasury trap"; instead this is a buying opportunity, says Robert Tipp, chief investment strategist at Prudential Fixed Income.


Sure, precision-timing the Fed's policy changes may prove impossible, especially when the Fed itself wavers on when it will slow, then stop, juicing the economy. As markets tried to outmaneuver the Fed in the third quarter, stocks wavered from historic highs then revisited new records when Ben Bernanke and crew tabled a "tapering" of long-term bond purchases. In anticipation of tapering sooner versus later, bond prices dropped and yields rose. Then the Fed slowed the whole enterprise. Again, the bond market reaction was orderly.


The Fed's taper tease "crash-tested the market," Tipp said. And, he added, bond markets passed the test. Intermediate-term government bond funds, for example, finished the third quarter up 0.4% on average, Morningstar reports, while short-term counterparts were essentially flat with a 0.1% return. Long-term funds, with their higher sensitivity to interest-rate moves, lost 2.4%


Tipp acknowledges that federal debt and budget overhangs challenge the U.S. government and tarnish the appeal of Treasurys relative to other higher-yielding bond classes. But he argues the U.S. fiscal situation is vastly better than balance sheet struggles in Europe, Japan, and China.That's why he's a limited buyer of Treasurys for portfolio insurance.


When it comes to yield, he prefers the attractive risk-reward of longer-term, higher-rated corporate bonds paying on average some 5%-6%, compared to a 10-year Treasury hovering above 2.6%.


2. Corporate unity


Yield-hungry investors snapped up the mammoth bond deals that made their way to the block in what was otherwise a deathly quiet corporate debt market in the quarter. For example, Verizon (VZ) sold $49 billion worth of bonds in eight parts over recent weeks.


The corporate debt market is healthier than it's been for some time and investors should find buying opportunities. In fact, investment-grade corporates weathered the tapering buzz better than stocks and other bond classes, said Jim Sarni, managing partner with Payden & Rygel.


"They're not only income-generating, but tend to do well in the very same environment that would cause pressure for faster rising rates. That is, an economy performing better than expected," Sarni noted. "As we move back to a risk-on environment, [investment-grade corporates] are a stock in a bond coat. And a nice coupon to go along with it."


In contrast, higher-yield corporate bonds benefit from the same economic scenario but aren't currently paying investors enough for taking on a riskier company, Sarni said. One of Morningstar's top-ranked high-yield bond funds is Fidelity High Income Fund (SPHIX), which gained about 2% in the quarter -- in line with the high-yield bond fund category's 2.2% average return.


Meanwhile, bank-issued bonds have the attention of Prudential's Tipp, as the financial sector deleverages, whips balance sheets into shape, and adjusts to existing in a new regulatory world.


3. Munis on the mend


Buy Local. Depressed prices have many analysts jumping at perceived bargains across the muni-bond space. Default risk from Detroit and other stretched cities and states, and risk of a lasting impact from government service sequester, sullied the broader sector unnecessarily, they said.


The muni team at Invesco believes recent increases in home prices will lead to greater tax receipts, adding 0.25% to U.S. GDP growth over the next year. Increases in tax revenues will lead to hiring and capital spending at state and local levels, they said.


Morningstar's highest-rated national muni-bond mutual funds include T. Rowe Price Tax-Free High Yield Fund (PRFHX) , Fidelity Intermediate Municipal Income Fund (FLTMX) and Fidelity Tax-Free Bond Fund. In the third quarter, short-term national muni funds rose 0.3% on average, while intermediate-term funds were up 0.2%. Long-term national muni offerings lost 1.1%. The best-performing muni category: intermediate-term California bond funds, up 0.8%.


Improved revenue collection means higher credit quality sweetens muni bond yields that are already "nipping at corporate yields" even before the tax advantage is factored in, said Payden & Rygel's Sarni. "Companies, they unfortunately can go away," he said. "Cities, states, they don't go anywhere."


Rachel Koning Beals is a Chicago-based freelance writer and editor.

-Rachel Koning Beals; 415-439-6400; AskNewswires@dowjones.com


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10-01-13 1512ET

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