What should you do about bond allocations in 2011?

If interest rates can only go up from here, shouldn’t you minimize your exposure to bonds? Not according to Zane Brown, a fixed-income strategist from Lord Abbott who addressed a crowd of advisors at the IMCA New York Consultants Conference.

“Not all bonds are created equally,” he said. “Focus on credit-risk sensitive bonds instead of interest-rate sensitive bonds.”

Avoid Treasuries, TIPs, agency bonds, and high-quality corporates because you’re not getting compensated for holding them, Brown said. But credit-sensitive bonds such as high-yield and convertibles are likely to get upgraded and very unlikely to default in a recovering economy, where these bonds act more like stocks. If the recovery continues high-yield spreads may narrow. Other good options are floating rate bonds that aren’t locked in. All three categories did well in the fourth quarter of 2010.

The irony is that in this environment Treasuries are far more risky than junk bonds

Banks may try to unwind their Treasury position putting even more pressure on that market and while tips do well when interest rates are rising, they don’t do well when rates are rising because there’s increased monetary supply. In that case, he said, the yield on TIPS’ rises but the prices fall. 

The job of selecting fixed income will be easier this year than last year, when everyone was piled into Treasuries in fear of a double-dip recession, which didn’t happen and is far less likely to happen now. The savings rate has gone from zero to 6% and consumption and growth are around 2%.

Brown ran through the reasons why we’re unlikely to have rising rates in the near future. “What will push rates higher? Wage inflation?” he asked. “Fat chance when you have 9% unemployment.” He said we weren’t likely to have price inflation either because of excess capacity. And he argued that commodity inflation is not leading to higher prices either. Even though oil and steel were more expensive, auto prices for example have been falling. And while cotton prices are high, apparel prices are down. Monetary inflation is still low, because while money is floating out there, banks aren’t lending it.

“There’s a big blob of money but it’s not being used, and the Feds can always pull some of that money off the table using a new tool, we didn’t have before in the form of time deposits for banks.

Brown also contends that fear of municipal bonds is way overblown. The $6.2 billion in muni defaults in 2009 were a mere 0.23% of the whole $2.8 trillion muni market and most of those issues were less than $10 million in size and more than 50% were backed by Florida real estate.

He said municipal governments were making the proper adjustments, cutting spending and raising taxes, and the actual versus the budget financials for municipals projects are often available. While you may have to pick carefully, there are good opportunities, he said. For example, you want to invest in a children’s hospital rather than an amusement park.