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1997-98: REVIEW AND OUTLOOK | INCOME INVESTOR / TOM
PETRUNO

'Defensive Plays' Earn a Newfound Appeal

January 04, 1998|TOM PETRUNO

If you have already decided that it's time to play it safe in financial markets--or at least safer--you have plenty of company.

U.S. investors have been moving in droves in recent months into so-called defensive securities, including Treasury notes and bonds, utility stocks and real estate investment trusts.

The common denominator of these investments: They generate significant cash income in the form of interest or dividends.

What Wall Street is in effect saying, of course, is that it is increasingly concerned that stocks overall won't appreciate much in value in 1998, and that share prices may in fact decline--after three years of stellar gains.

If investors can't count on price appreciation, many of them naturally are going to seek returns in some other form. That usually means interest or dividend payments.

Hence, the flood of buyers that have chased after Treasury securities since late summer. The yield on the bellwether 30-year Treasury bond has tumbled from 6.55% on Sept. 2 to a four-year-low of 5.85% as of Friday as buyers have tripped over one another trying to lock in fixed yields.

But can the bond rally continue, with long-term yields nearing their lowest levels in a generation?

Some analysts think so. Edward Yardeni, chief economist at Deutsche Morgan Grenfell in New York and a savvy trend caller in the economy over the last two decades, believes the 30-year T-bond yield could fall as low as 5% by 1999.

The real, or after-inflation, bond return is key, Yardeni says: If the deflation wave emanating from Asia helps depress U.S. consumer inflation in 1998 to a mere 1%, as he believes could happen, then real yields on bonds now are historically far above average.

Because inflation is the main enemy of fixed-return investments such as bonds, if the inflation threat continues to recede, investors should be willing to accept lower bond yields--in theory, at least.

Bonds have something else going for them: the federal government's declining need to borrow, thanks to an actual budget surplus over the last 12 months--the first since 1970. That reduces the supply of new Treasuries in the market.

Still, many investment pros aren't convinced that Treasury yields can go much lower. Robert Rodriguez, a principal at First Pacific Advisors in Los Angeles and a bond market veteran, thinks it's more likely that the 30-year T-bond yield will bounce around in the 6%-to-7% range over the next year.

Despite low inflation, he said, real bond yields may remain high because the market fears that the federal budget situation will deteriorate dramatically in coming years without a permanent financial fix for the Medicare program.

For now, however, investors' appetite for decent--and safe--yields doesn't appear to be waning. In addition to Treasury bonds, two stock sectors have been hot in recent months:

* Utilities. Both electric and telephone utility stocks have attracted hordes of buyers lately. Not only do many of the stocks offer annualized dividend yields in the 3%-to-6% range--well above the paltry 1.7% average blue-chip stock yield--but their businesses are largely dependent on the U.S. economy.

Thus, unlike blue-chip multinational shares, many utility stocks offer a way to avoid any exposure to ailing Asian economies, or to any foreign economies for that matter.

* Real estate investment trusts. These trusts offer a simple securitized way to own diversified portfolios of commercial, industrial and residential real estate, with rents and profits on the properties passed through to shareholders in the form of dividends.

REITs, like utilities, typically are exclusively "domestic" plays, because generally their properties are all within the United States.

REITs' annualized yields now are in the 4%-to-7% range.

For investors who don't feel comfortable picking individual stocks, mutual funds that specialize in utility or REIT stocks offer an easy way to buy into those asset classes. (See lists in special Morningstar mutual fund tables in this section.)

There are, of course, many other ways to invest for income: corporate bonds, tax-free municipal bonds, mutual funds that buy corporates or munis, bank savings certificates and money market mutual funds, to name a few. What investors must keep in mind is that, with the exception of very short-term income investments such as money market funds, "safe" is a relative term with regard to most higher-yielding investments.

If, for example, market interest rates should soar in 1998 instead of declining, bonds bought at today's fixed yields would tumble in principal value. Likewise, utility shares and REITs could plunge in price if interest rates jumped--the mirror image of their performance as rates have fallen.

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