BondsOnline Advisor:  Tools for the Income Investor
December 2005

By Stephen Taub

(As 2005 come to a close, we are refining our objectives for 2006 of the BondsOnline Advisor.  Look for expanded coverage of asset types – and specific recommendations - that help you manage your income portfolios: stocks, bonds, trusts and limited partnerships, and REITs.)

As the year ticks down, several things are clear. The Fed is winding down its tightening policy, the economy is relatively strong, and the yield curve is nearly flat.

What should investors do, then, as we head into 2006? Here is how a number of major investment banks, money management and research firms see the coming year shaping up, as well as the strategies they recommend for their clients.

SMITH BARNEY
Smith Barney notices that investor interest in inflation-indexed securities has declined in the last month or so as GDP and productivity surprisingly perked up and the job market remained steady, lessening inflation fears. Before that, TIPS had staged an impressive four-month rally since the breakeven point (the point at which the value between TIP and a regular, non-inflation protected Treasury are the same) in July. “We see a similar opportunity for TIPS today,” it adds, although it warns it is not as compelling as in July.

A separate Smith Barney report points out that Citicorp’s economists expect the Fed funds rate to peak in early 2006 at 4.50% or 4.75%. They also predict the 10-year Treasury yield will average only slightly more in the first quarter of 2006 than it does currently (4.54%), and then begin to decline modestly as the economy slows, reducing inflation-related risks. The target for the fourth quarter of 2006 is an average of 4.25%. As a result, the investment bank is looking for the Treasury yield curve to remain extremely flat, and both long-term and short-term interest rates to remain in a relatively narrow range for much of the year. Citi also expects the narrow spreads between short and long-term rates in the U.S. and the rest of the world will persist.

Citi’s muni analysts predict that municipal bond yields as a percentage of Treasury yields will remain in a very narrow band, as they have been in 2005. “In a gradually declining rate environment, we would expect munis to under perform slightly, all other things being equal,” it adds.

STANDARD & POOR’S
Standard & Poor’s Investment Policy Committee reiterated its recommended model asset allocation of 65% stocks, 20% bonds, and 15% cash for 2006. It suggested that 20% of the stock allocation should be set aside for non-U.S. equities. Its year-end target of 1360 for the S&P 500 Index implies a roughly 9% total return (including dividends) from S&P’s year-end 2005 forecast of 1270.

“The increasing likelihood that Federal Reserve monetary policy tightening will end as a result of continued strong productivity growth and low core inflation will likely generate a positive macro economic environment for equities,” said S&P’s Chief Investment Strategist, Sam Stovall. “Valuations remain attractive, particularly with the S&P 500 Index trading… at a P/E of 16, based on estimated 2005 operating EPS”. This represents a discount to the long-term average PE of 20 times forecasted operating earnings over the 1988-2004 time-frame.

S&P’s credit group points out that the number of “fallen angels” - former investment grade corporate bonds that were knocked down to junk status – was greater than a year ago. However, the number of entities at risk of declining into fallen-angel territory is lower than last year. Year-to-date, fallen angels still lag rising stars: the gap between them, at 20, is the highest margin since 1997. The sectors most vulnerable to generating fallen angels are high technology, media and entertainment, oil and gas exploration and production, and retail/restaurants.

MERRILL LYNCH
Merrill Lynch’s convertibles analysts noticed that in 2005 companies increasingly reoriented financial strategies to be more in line with shareholder interests. “We expect that the theme of under-levered balance sheets will continue into 2006, providing management the scope to create opportunities for shareholder returns,” they add.

Merrill singles out 13 issues that it believes have the potential to enhance returns through management action, sometimes catalyzed by shareholder activism.  The following eight are expected to increase dividends: Aetna (AET), Alltel (AT), Coca-Cola Enterprises (CCE), Mettler-Toledo International (MTD), PG&E (PCG), Toll Bros (TOL), Wellpoint (WLP) and Xerox (XRX).

PIMCO
Legendary bond guru Bill Gross says in his December letter to investors that by this time next year central banks around the world will be initiating easing cycles that “favor front-ends of yields curves, longer than average duration portfolios and a high quality emphasis, within the context of a slowing U.S. and global economy with contained inflation.”

UBS
UBS also believes Treasury yields still look somewhat low. “Strong economic growth during the first half of 2006 should keep upward pressure on bond yields,” it adds. However, it expects bond yield increases to moderate as growth cools in the later half of the year and core inflation moderates.

It singles out agency securities as being relatively attractive compared with historical valuation levels. “As a result, we are inclined to view the recent widening in spreads to Treasuries as an opportunity to selectively add to agency positions on a tactical basis,” it adds.

CREDIT SUISSE FIRST BOSTON
CSFB warns that risk appetite is now at an 11-year high. “The recent move in prices has been very broad-based,” it adds. “Emerging market and developed market asset prices, including global stocks and global bonds, are all at or near euphoric levels.

“Riskier components have strongly outperformed safer ones over the past six months,” it adds.

Does this mean that risky assets are riding for a big fall, and probably sooner rather than later? The investment bank says history does not support that view.

“The bottom line is that risky assets are now (very) overbought but they are not overvalued,” the bank adds. “It will probably take a genuine inflation or growth scare to reverse the current tide of investor optimism.”