There’s been speculation that a bubble is forming in Treasuries. Do you think that’s an appropriate characterization?

Benjamin Bailey: I wouldn’t necessarily term it a bubble; in a lot of ways, it’s a valid response to an extreme scenario, a time when catastrophe appeared imminent. And with the prevailing lack of liquidity, especially back in November and December, the Treasury market was the place to be.

People wondered what was safe after the Reserve Primary fund broke the buck and other short-term funds started to fall apart. A lot of funds, especially the short-term bond funds, rushed headlong into Treasuries as a means to assuage clients’ concerns about their investments. At that point safety trumped returns; it didn’t matter if they were only getting 15 or 30 basis points.

Again, I wouldn’t classify the move to Treasuries as a bubble because it was a rational response.
There were times when it felt like things were completely falling apart. Thankfully, things have settled down since then. Rates are rising on Treasuries, recently breaking 4 percent for the first time in months.

Are buyers wary of the government’s mounting debt burden or just recovering their risk appetites?

Delmar King: The Federal Reserve is forcing rates down on the front end of the curve; that inevitably impels investors to take risks, which is exactly what they’ve started to do. In that sense, the Fed’s efforts have been successful. But that’s only part of the equation.

The latest Treasury International Capital (TIC) data suggests that foreign investors have pulled back from Treasuries; to make these bonds an acceptable option for domestic investors, rates had to go up. Especially at the longer end [of the yield curve] rates had to reach a level where they would be compatible with long-term inflation expectations. And over the last month or so, the likelihood of inflation has really sunk in–particularly as the equity market has done well. There’s also the thought that we’re finally hitting the bottom of this recession, building the expectation that the economy will finally turn around. That’s our current take on the Treasuries market.

The BRIC (Brazil, Russia, India and China) nations recently issued a statement calling for a diversified monetary system. Is there a chance they’ll stop buying US debt?

King: There is that fear. In reality, I think political goals are the driving force behind these statements, particularly on the part of the Chinese. Perhaps the countries are seeking a bigger role in the International Monetary Fund (IMF) and other international agencies–a role commensurate with their stronger financial position and economic status relative to the US and Europe. Those are complex issues to unravel, and there are a number of potential interpretations.

Are Treasuries an attractive investment at this point?

Bailey: As Treasuries have backed up they’ve become a more interesting investment opportunity. Now that risk is returning to vogue, short-term agencies have started to tighten so much that their spread over the two-year Treasury is about 20 basis points–quite low considering that the long-term average hovers around 30 basis points. In other words, agency bonds don’t yield much more than Treasuries, which also offer superior liquidity. In some ways, agencies are becoming less attractive than Treasuries because of the liquidity premium you get with Treasuries thanks to the small bid/ask spread. On those two fronts, they’re definitely more attractive than they were.

King: If you look at the 10-year Treasury versus where it’s been over the last couple of years, it’s starting to trade in the range it did in 2007. Based on our outlook for the economy, that’s probably a reasonable level for Treasuries over the next 12 to 18 months.

But there are potential problems on the horizon. If interest rates go up much further, given the weakness of the economy, that will create a drag. If the ten-year Treasury note ranges between 4 and 4.5 percent, that would feed back into the mortgage market and make it difficult for consumers to refinance mortgages or purchase homes. And with the ever-expanding glut of houses on the market, we’ve got to figure out a way to clear this oversupply; housing markets will continue to languish if mortgage rates rise sharply.

What’s your economic outlook for the next year?

King: We think that the worst has probably passed and expect the economy to improve slowly–we don’t foresee robust growth. There are several impediments that will weigh on recovery, from the massive inventory of unsold homes to the crippling amounts of bad debt on banks’ and investors’ balance sheets. Because household wealth has eroded substantially and debt levels remain elevated, there’s significant pressure to address that debt by increasing savings. During this refractory period, any growth will likely be sluggish and won’t pick up until the financial system purges itself of risky and nonperforming assets. Given those challenges, we don’t expect the economy to grow substantially until 2011.

What areas are most attractive for bond investors right now?

Bailey: There are a few areas we still like, even though they’ve tightened quite a bit: Utilities and pharmaceuticals are two of our favorites. The latter group has run a great deal, but we still like some of the names because we think if there’s any widening in spreads, those are the names that were protected previously. Recently, we’ve been able to buy a few names in the BBB-rated area that we think have some value, but they’re more off-the-run names, names that aren’t as well-known and liquid and take a little bit of extra work.

One example is Portland General Electric 6.1% due 04/15/19 (CUSIP: 736508BQ4). When we bought that bond we were investing in the expansion of their windmill project in the Columbia Gorge and the transmission facilities to bring that power into the Portland/Salem area.

On the healthcare side, we own Novartis 4.125% due 02/10/14 (CUSIP: 66989HAA6).

King: Regardless of Standard & Poor’s (S&P) caveats, we continue to find opportunities in commercial mortgage-backed bonds. The last couple weeks have been difficult for the segment in the wake of S&P’s report, but the yields generally remain attractive, especially among the more-seasoned super seniors. This area still faces a lot of issues and requires a great deal of analysis to separate the wheat from the chaff, but there are some great opportunities available if you’re selective and perform sufficient due diligence.

What are some of your other favorite names?

King: There are a few names that we own not only because they’re attractive investments but also for their social value. The first is the International Finance Facility for Immunization 5% due 11/14/11 (CUSIP: 45951BAA7). That’s a supranational security that trades very much like an agency bond and exhibits a comparable spread. The proceeds from that bond were used to finance immunizations in the developing world. Several of the governments in Europe, the UK in particular, spearheaded this initiative and guaranteed the issue, which back in 2006 provided billions of dollars to combat disease by immunizing large populations across Africa and some of the southern Asian countries.

Another bond that jibes with our socially-responsible mandate is Avon Products 5.625% due 03/1/14 (CUSIP: 054303AV4). We’re big fans of micro-lending and, believe it or not, this is an investment in that vein. Avon Products (NYSE: AVP) generates more and more of its growth from emerging markets, where it offers women the opportunity to contribute income to the family’s budget. And the cosmetics themselves are useful products that make people feel a little bit better about their appearance.