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Despite recent Dow surge, bonds still look good

As of Tuesday, the Dow Jones industrial average had pasted together four consecutive gains for the first time since early August and already the heralds were proclaiming the advent of the new bull market. All the usual cheerleaders were dusting off their forecasts and raising their targets.

Stocks guru Abbie Joseph Cohen conferred with her crystal ball and sees the Dow returning to over 10,000, oh, any time now. The other boosters are crawling out of their bunkers, turning their backs on their past glowing endorsements of Enron and WorldCom, and adding their voices to the chorus of hosannahs.

Signs of new optimism are popping up like tulips in the spring. Why, just this week, The Globe and Mail ran a column by Rob Carrick that revealed the results of a new survey of six prominent equity mutual fund managers, and surprise! -- none of them thought now was a good time to pull out of mutual funds. This is a bad time to sell, they say. Of course, if everyone took their money out of mutual funds, it would indeed be messy for fund managers, not to mention the negative impact it would have on management's fee revenues, and thus on managers' bonuses. On the Street we call this talking from a position.

I'll be more interested when mutual fund managers tell me that this is a good time to pull out of mutual funds, which I figure will be about when my tailor tells me I don't really need a new suit, or when my car dealer tells me that my clapped-out Dodge Veg-a-Matic has a couple more years of useful life, or when CNBC finally finds a stock that it doesn't like.

Mutual fund managers want everybody to put all their money in mutual funds -- particularly in the ones that they manage. Stockbrokers want to sell stocks, and analysts want to write reports that make you want to buy the stocks they sell. It's an old cliché on the Street among dealers to say, "We own, and therefore recommend that YOU buy." Lately, with the recent stories about Research in Motion Ltd. and Credit Suisse First Boston and the alleged extortion of investment banking fees in exchange for favourable analyst coverage, it seems like that old chestnut has morphed into something more like "We're getting paid and therefore recommend YOU buy." But the punter has no need to be nervous. After all, these are financial professionals. (Kids, don't try this at home.)

Part of the new bullish mantra is to stay away from bond mutual funds, and by extension, bonds themselves. After all, interest rates are at historic lows, surely they can't go any lower, and if they back up, then bond prices go down. The inverse relationship between bond prices and yield is mentioned in virtually every newspaper and magazine article about bonds that has ever been written, yet Vanguard Funds, the U.S. mutual funds giant, estimates that 70 per cent of investors still don't understand it. So it's not hard to understand why retail investors might be loath to get too involved with bonds.

Still, they're missing some opportunities. General Electric Capital of Canada Funding, for instance, launched a $425-million (Canadian) issue of seven-year bonds this week, earmarked for the retail investor. They feature a 10/23/09 maturity and a coupon of 5.65 per cent, priced at 82 basis points over the Canada 5.5 per cent/09 issue. Rated triple-A, the GE bonds yield 5.705 per cent. That's more than Ontario Savings Bonds, which are lower rated (not to knock em, though I own a bunch, and they have lots of other attractive features such as being cashable at par and having a government guarantee).

Now, it's true that if interest rates climb, the market price of the bond will decrease, by about 6 cents for every basis point of yield increase. But if you bought them at issue, you still earn 5.66 per cent, and get all your money back in 2009. And you can reinvest your coupon payments at higher yields. If rates drop, you still get your 5.66-per-cent coupon stream and the market price of the bond rises by 6 cents a basis point, affording a chance for capital gains. With inflation mild, what's wrong with a near risk-free 5.66 per cent? A lot of the stuff I read suggests that stocks will be hard-pressed to average much more over the next, oh, seven years, say, and the bonds are much less volatile. (Bond mutual funds are another can of worms entirely. There your return also depends on the ability of a fund manager to out-trade the market. Some do, some don't, and nobody does it all the time. Buying bonds and holding them to maturity is much less volatile and has much lower carrying charges.)

And who's to say that bond yields aren't going lower? Bond yields have risen in the past few days, but that's been a function of roaring stock markets, not because of sudden new strength in the U.S. or global economy or a lessening in the current geopolitical chaos. The economic signals are cloudy -- they don't call it the dismal science for nothing and as for the new bull market, well, they say that some of the biggest rallies occur during secular bear markets. I don't see tech stocks such as Nortel making money yet, and they keep burning cash and lowering their costs and break-even point, just like they've been doing every quarter since the stock peaked at $124. I'm reserving judgment until I see that the next few quarters don't bring more of the same.

So, in the meantime, resist the blandishments of those pitching stocks and remember the bond trader's axiom: Buy bonds, and you'll wear diamonds. After all, while that could very well be a vigorous young bull snorting his optimism, it could also be just as easily be another fatted calf destined for sacrificial propitiation of Mammon's more ursine demi-gods.

Harry Koza is senior analyst in Canadian markets for Thomson Financial/IFR. At various times in his career, Mr. Koza has been a prospector, metallurgist, project manager, engineer, as well as an institutional bond salesman for 15 years. His current area of expertise is in high-yield distressed securities and corporate bonds in general.
This column first appeared on For more exclusive analysis, please see the Web site.

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