Fed pause creates options

Your Money

August 27, 2006|By Andrew Leckey | Andrew Leckey,Tribune Media Services

What Federal Reserve Chairman Ben S. Bernanke doesn't do can help you.

The Fed's decision to at last lay off the interest rate increases that characterized Bernanke's early tenure opens the door to a new world of possibilities.

Experts who hope Fed policymakers will be content to simply sit on their hands for a while are dishing out suggestions to everyday investors:

Consider leaving short-term certificates of deposit behind and instead invest in three- to five-year CDs. Yields are about as good as they'll get for some time.

"It absolutely is a good time to lock in CD rates," said Steven Shachat, portfolio manager for Alpine Tax Optimized Income Fund. "First of all, CD rates are relatively attractive and, once the Fed actually does go from inaction into a rate-easing mode, short-term rates will fall fastest."

Expect relatively flat mortgage rates with perhaps some modest slippage as Fed inactivity provides homebuyers and borrowers with some relief. Mortgage rates have already shown they can decline.

"We think fixed-rate mortgages will hang around current levels or come down 25 basis points [a quarter of a percentage point] or so," said William Hornbarger, fixed-income strategist with A.G. Edwards & Sons. "We're not looking for any increase in rates."

Stretch your bond and bond fund durations from short-term to intermediate-term because that's where results should be strongest, experts said. Declining short-term rates will improve the value of bonds with somewhat longer maturities.

"The Federal Reserve is finished with increases," predicted Anne Briglia, senior fixed-income strategist with UBS Wealth Management Research. "It's time for investors to consider extending their bond maturities, and I like the seven- to 10-year intermediate portion of the curve."

Recent news about inflation seems to validate Bernanke's decision to leave rates unchanged for the first time in two years. But no one's saying inflation is dead altogether or that world turmoil won't keep markets on edge.

Based on nagging domestic concerns such as housing, it makes sense to stick with high-grade corporate and municipal bonds rather than high-yield choices with lower credit quality that will be in trouble if the economy sours.

"It's not an understatement to say that in coming months the Fed will be very dependent on economic data in its decisions," said Michael Brandes, fixed-income strategist in Smith Barney's investment strategy group. "Yet whether the Fed is done now or will be done in another three months, we are at the tail end of the rate cycle and bond yields will be in a tight range or declining."

Brandes said investors should use a "barbell" approach to bonds, concentrating their holdings at the high and low ends of the curve with less emphasis on the middle. That way they're best able to take advantage of short-term rates but also lock in potentially better-yielding returns before long-term rates decline in the coming year, he said.

"We'll be looking at a number of Federal Reserve meetings where nothing happens, with an easing of rates to occur sometime in 2007," Shachat said. "Investors should start looking at longer bonds because that obviously will profit if rates start to fall."

Shachat's Alpine Tax Optimized Income Fund, specializing in short-term national municipal bonds, has a tax-exempt annualized yield of 2.9 percent in 2006 to rank in the top 2 percent of its category. Its three-year tax-exempt annualized return of 2.7 percent ranks in the top 8 percent of its peers.

The consensus is that the news on mortgages is generally good.

"Mortgage rates will be stable, though I wouldn't say down because they shouldn't be much lower in the short term," said Michael Schultz, lead manager for Summit Short-Term Government Fund. "Meanwhile, conservative investors might consider locking in three- to five-year CDs, though not with 100 percent of their funds."

Schultz's Summit Short-Term Government Fund has a one-year taxable annualized return of 3.13 percent, ranking in the top 7 percent of its category. Its three-year taxable annualized return of 2.05 percent places it in the upper half of its peers.

"I would look at a short- to intermediate-term bond fund because I don't think you'll be rewarded for investing in a fund with a very long duration," Schultz said. "However, with what's happened in the market and the Fed looking to pause, extending durations somewhat is probably a good thing to do."

What kind of a job is Alan Greenspan's successor doing?

"Bernanke is doing a good job, even though the market challenged his inflation-fighting credentials the past couple of months and he had a few rough spots in his communication style," Briglia said. "He's obviously very intelligent and learned quickly, so he's off to a good start."

Andrew Leckey writes for Tribune Media Services.

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