Deposits at FDIC-insured institutions are now insured up to at least $250,000 per depositor through December 31, 2013. On January 1, 2014, the standard insurance amount will return to $100,000 per depositor for all account categories except for IRAs and other certain retirement accounts which will remain at $250,000 per depositor. (This supersedes the October 3, 2008 changes.)

May 20, 2009

President Obama’s budget proposes to hike the marginal tax rates of the wealthy to 36% and 39.6% beginning in fiscal 2011, and to increase by 5% the capital gains and dividends tax rate for the wealthy - tax changes that market participants say could lead to higher demand for tax-exempt bonds.

“The Obama tax hike [on the marginal rates] would mean that muni investors could buy bonds about 40 basis points richer in yield to achieve the same after-tax yield,” said Matt Fabian, a managing director at Municipal Market Advisors.

Wealthy would be defined as married couples earning over $250,000 and individuals earning $200,000 or more.

However, the administration has abandoned a proposal aired in a budget outline released in February that would have capped the amount of deductions taxpayers could take at 28%, another move that may have pushed wealthier investors into the muni market.

The most recent budget document also shows an even smaller estimate for how much the federal government will pay for the new Build America Bonds program than a document released Thursday.

However, market participants said the discrepancy does not really matter since the higher numbers were already underestimating the amount of payments that will be made under the program.

In an appendix to the budget released last week, the administration estimated that the Treasury Department would spend $91 million in fiscal 2009 and $340 million in fiscal 2010 on BABs, which it said included Recovery Zone Economic Development Bonds

But the Analytical Perspectives document released yesterday estimated just $50 million and $192 million for BABs during those years. Neither administration officials nor market participants could explain the differences in the estimates.

Treasury officials say roughly $9 billion of BABs have been issued during the past two months since the program started. Clifford Gannett, the director of the Internal Revenue Service’s tax-exempt bond office, which is charged with processing the direct payments for those bonds, said Friday that doing “very conservative” math on those numbers indicates $90 million of payments on just those issuances.

It is possible that the budget numbers stem from revenue estimates put together when the BAB legislation was being drafted, well before anyone knew how popular they would become, sources said.

The BAB program, created by the stimulus law, allows governmental issuers to sell an unlimited amount of taxable debt and either receive a cash payment from the federal government or provide investors with a tax credit equal to 35% of the interest rate.

The Recovery Zone Bonds, $10 billion of which were authorized under the stimulus law, also would provide issuers with a cash subsidy, but that payment is equal to 45% of the interest rate, and there is no option to provide a tax credit to investors. The bonds are to be allocated to areas hit hard by unemployment in 2008.

The budget documents also provide some fresh details for the administration’s estimated savings of phasing out the Federal Family Education Loan student loan program and moving to a system in which all federally guaranteed student loans are originated directly by the Department of Education. Many state-level FFEL lenders, who are opposed to the switch, issue municipal bonds backed by their student loans.

By ending “subsidies” paid to FFEL lenders, the budget documents estimate savings of $24 billion over five years and $48 billion over 10 years.

But an appendix to the budget proposal shows that the federal government has historically overestimated the costs of subsidies for FFEL while underestimating the costs of the direct loan program.

For the roughly $811.7 billion of FFEL loans originated since 1992, the cost of each loan averaged about 8.2 cents per dollar, compared to original estimates of about 10 cents. Issuance costs for the roughly $249.8 billion of direct loans were about 4.5 cents for each dollar loaned, compared to estimates of about 0.6 cents.

Almost three quarters of the budget’s proposed $100.5 billion of grants to state and local governments would be used for transportation infrastructure, mostly highways.

The budget proposed some modest changes to transportation and infrastructure funding, including a new user fee that would fund the air traffic control system beginning in 2011.

The administration argued that the current excise tax that is levied on users based mostly on airline ticket prices should be replaced by a tax related to the cost of services provided by the Federal Aviation Administration. If such a measure is taken, it will generate $9.6 billion in 2011 and existing aviation excise taxes could be reduced, according to the budget.

The administration also confirmed in its budget that it hopes Congress will create a national infrastructure bank and fund it at $5 billion in fiscal 2010. However, only a portion of that would be spent in 2010, the budget said.

The budget estimated that the federal government will provide $73.4 billion of transportation in grants to state and local governments in fiscal 2010, up about $11 billion from this fiscal year. Federal transportation grants would reach $102.3 billion in fiscal 2019 under current policy, according to budget documents.

The administration also proposes a five-year, $5 billion high-speed rail state grant program that would add on to the stimulus funding provided for high-speed rail development.

In addition, the budget includes $3.9 billion for the clean and drinking water state revolving funds.

By Peter Schroeder, Audrey Dutton and Andrew Ackerman, Bond Buyer
May 12, 2009

WASHINGTON — The slumping U.S. economy barely improved early this year, with businesses slashing spending and inventories, according to a surprising report indicating the recession didn’t ease as much as expected.

Gross domestic product decreased at a seasonally adjusted 6.1% annual rate January through March despite rising consumer spending, the Commerce Department said Wednesday in its first estimate of first-quarter GDP.

The 6.1% drop was much bigger than Wall Street expected and hardly different than a 6.3% plunge in the fourth quarter, when the recession that began in December 2007 deepened.

Economists surveyed by Dow Jones Newswires expected a 4.6% drop in GDP during the first three months of 2009. With a 0.5% drop in the third quarter, GDP has now fallen three consecutive quarters. That hasn’t happened in 34 years, since third-quarter 1974 through first-quarter 1975.

Price indicators within Wednesday’s report suggested inflationary pressures rose in first-quarter 2009, easing fears of deflation. For instance, the price index for personal consumption expenditures fell by 1.0%, a decline much smaller than the fall of 4.9% in the fourth-quarter 2008. The PCE price gauge excluding food and energy rose 1.5%, after increasing 0.9% in the fourth quarter.

Weaker investment in housing combined with the enormous inventory adjustment to pull the economy downward. But the aggressive drawdown of stockpiles of goods, while hurting the economy in the short run, is beneficial because it is an important step toward bringing inventories under control and ending a production freefall. U.S. industrial production retreated a fifth straight month in March, recent data show. Over the past 12 months, output was down nearly 13%. Capacity use by industries receded to 69.3%, a historical low since records began in 1967.

First-quarter GDP would have fallen farther if not for improvement in trade. Exports fell — but imports dropped even more.

GDP acts as a scoreboard for the economy by measuring all goods and services produced. Its biggest component is consumer spending, which accounts for about 70% of GDP. First-quarter spending increased 2.2%, after dropping 4.3% in the fourth quarter.

Purchases of durable goods rose 9.4% in the first quarter, after decreasing by 22.1% October through December. First-quarter non-durables spending climbed by 1.3%. Services spending rose 1.5%.

Overall, consumer spending contributed 1.50 percentage points to GDP; it had dropped 2.99 percentage points in the fourth quarter.

But another component of GDP, housing, took a large bite out of the economy. Residential fixed investment fell by 38.0%, reducing overall GDP by 1.36 percentage points. Fourth-quarter investment had fallen 22.8%, taking 0.80 of a percentage point out of GDP.

International trade boosted the economy early this year, adding 1.99 percentage points to GDP. U.S. exports plunged 30.0% and imports decreased 34.1%. In the fourth quarter, trade deducted 0.15 of a percentage point out of GDP; exports in that period were 23.6% lower and imports fell by 17.5%.

First-quarter business spending dived 37.9%. Investment in structures went down 44.2%. Equipment and software outlays decreased 33.8%. Overall fourth-quarter outlays by businesses retreated 21.7%.

Businesses dumped inventories by $103.7 billion. Inventories fell $25.8 billion in the fourth quarter and $29.6 billion in the third quarter. The big deceleration siphoned 2.79 percentage points out of January-March GDP.

Real final sales of domestic product, which is GDP less the change in private inventories, fell at a 3.4% annual rate in the first quarter. Fourth-quarter sales fell by 6.2%.

Federal government spending decreased 4.0%, after rising in the fourth quarter by 7.0%. State and local government outlays fell 3.9%, after going down by 2.0% in the fourth quarter.

Other price inflation gauges in the report include the price index for gross domestic purchases, which measures prices paid by U.S. residents. It fell 1.0%, after decreasing 3.9% in the fourth quarter. The chain-weighted GDP price index increased 2.9%, after increasing 0.5% in the fourth quarter.

By Jeff Bater
Of DOW JONES NEWSWIRES

 Evolution or Revolution?

The title of this Outlook, “The Future of Investing,” is a theme that will take the evolving years to resolve, let alone the next few days. Still, PIMCO is an organization that loves a challenge. All of us here today would agree that the answer to both questions will be highly dependent on the evolution of the global economy, and when it comes to those questions PIMCO has excelled because of its long-term secular outlook. It has paid dividends for our clients for over 30 years and it should do so now as well. The fact is, that the future of investing will depend on the long-term future of the global economy – its nominal growth rate and the distribution of that growth between public and private interests. And so we should start at the beginning, or perhaps at the top, of our top-down process – the future of the global economy.

 I. Future of the Global Economy

The future of the global economy will likely be dominated by delevering, deglobalization, and reregulating, yet if so, it is important to state at the outset that we do not envision a mean reversion, cyclically oriented future, but instead a new world where players assume different roles, and models relying on bell-shaped/thin-tailed outcomes based on historical data are less relevant. Historical models look backward while modern-day finance is being fast forwarded and reconstituted almost as we speak.

 1) Delevering – The prior half-century of leveraging and the development of the amorphous shadow banking system was growth positive. Major G-10 economies became dominated by asset prices and asset-backed lending most clearly evidenced in housing markets. Excess consumption was promoted, and investment based on that consumption followed in turn. Savings rates in many countries including Japan, the U.K., and the U.S. fell towards zero as the reliance on rainy day thrift faded. Deleveraging of business and household balance sheets now means those trends must reverse, and as they do, growth itself will slow, bolstered primarily by government spending as opposed to the animal spirits of the private sector.

 This topic is one which literally could take hours to discuss, and at PIMCO forums and Investment Committee meetings, it does. There are those of us here as well as highly respected economists outside of PIMCO who would suggest destruction as opposed to slow growth, and they may have a minority, but not insignificant, case. Much depends on the effectiveness of policy responses and the simplistic answer to a simplistic question. Can global financial markets and the global economy heal by pouring lighter fluid on an already raging fire? Can too much debt be cured by the issuance of even more debt? Must the debt supercycle come to an end by crashing and burning or does the world keep breathing with a whimper instead of a bang? We shall see, but there is a near certain probability that the financially based global economy of the past half-century will not return, nor will we experience the steroid driven growth excesses that it facilitated.

 2) Deglobalization – Lost in the wondrous descriptions of finance-dominated, Bretton Woods-initiated, global growth has been the adrenaline push provided by global trade and indeed portfolio diversification into a multitude of markets – developed or developing. Yet historians point out that globalization is not an irreversible phenomenon – witness the aftermath of WWI and nearly three decades of implosion. Now the beginning signs of trade barriers – “Buy American” and “British jobs for British workers” among them – as well as government support of locally domiciled corporations (banks and autos) suggest an inward orientation that is less growth positive. Additionally, “financial mercantilism” is an added threat – a phenomenon that speaks to growing pressure on banks to retreat from international business and concentrate on domestic markets.

 3) Reregulation – Academics, politicians, investors, central bankers and everyday citizens are questioning the economic philosophy that idolized free markets and their ability to self-regulate. The belief in uncapped and unregulated incentives producing unlimited upside but nearly always cushioned downside losses is fading. While Sarbanes-Oxley was a well publicized but relatively toothless response to the dot-com bust of nearly a decade past, today’s politicians have gained the upper hand, driven by a citizenry that has recognized the unbalanced, disproportionate distribution of incomes. The efficient market thesis, so prevalent in academic theory and market modeling is now in retreat, and perhaps rightly so. In its place, we will experience less efficient but hopefully less volatile economies and markets – monitored and controlled by government regulation. Executive compensation, of course, is just the poster child. Government ownership and control of vital financial and manufacturing institutions will politely be described as “industrial based” policy and “burden sharing,” but we should have no doubt that we will move significantly away from the free market model that has dominated capitalistic countries for the past 25 years.

 With the top-down framework for future global economic growth in place, let’s take a look at PIMCO’s outlook for the future of investing – evolution or revolution.

 II. The Future of Investing

Whether evolution or revolution it is important to recognize that the aftermath of an economic and investment bubble transitioning from levering to delevering, globalization to deglobalization and lax regulation to reregulation leads to an across-the-board rise in risk premiums, higher volatility and therefore lower asset prices for a majority of asset classes. The journey to a new stasis is a destructive one insofar as it affects previously assumed wealth. Rough estimates suggest that as much as 40% of global wealth has been destroyed since the beginning of this delevering process. In essence, asset prices, which are really only the discounted future value of wealth creation, go down – not only because that wealth creation slows down but because it becomes more uncertain. In such an environment, equity interests in the form of stocks, real estate or even high yield bonds become re-rated. Those who believe that capitalism is and will remain a going concern and that risk taking – over the long run – will be rewarded, must recognize that those rewards spring from beginning prices and valuations that correctly anticipate the global economy’s future growth path and volatility. In terms of that old maxim “buy low – sell high,” this means at the minimum that an investor during this period of re-rating must “buy low.”

 In turn, investor preferences towards risk taking, even when correctly calculated and modeled must be considered. Peter Bernstein has for several years counseled that policy portfolios structured for the long run and based on historical return statistics should be reconsidered. The standard pension or foundation approaches to policy portfolios are being challenged, he asserts, and PIMCO agrees. Stocks for the long run? Home prices that cannot go down? The inevitable levering of asset structures to double or quadruple returns relative to risk-free assets? These historical axioms must now be questioned. In fact, as of March 2009, the superiority of risk-asset returns are not what many assume them to be. For the past 10, 25, and 40 years, for example, total returns from bonds have exceeded those for common stocks.1 Home prices have declined a staggering 30% since their peak in late 2006, and have barely kept up with inflation for the last century according to Case-Shiller statistics. Commercial real estate when ultimately mark-to-market over the next several years will likely show similar results. In short, our stereotyped conceptions of what makes money are being challenged. As Bernstein says, there is no predestined rate of return. And a PIMCO corollary would counsel that future rates of return will be dependent on the beginning price and future growth rates and risk preferences that cannot necessarily be derived from historical models. Government policies will also play an important role, especially insofar as they impact long-standing property rights and capital structures. What I have previously described as a CQ – a common sense quotient – may take precedence over IQ and quantitative analysis in future years. How much of a benefit, for instance, did the renowned risk modeling of some of our major competitors produce over the past several years in terms of their bond funds and derivative-related products as compared to PIMCO’s? We invite comparison, not only of our own risk models, but our collective common sense quotient.

 What then does common sense tell us about future asset returns? Let’s revisit our previous conclusions on the developing environment for some clues. They include: delevering, deglobalization, reregulation leading to slow global growth, a heightened risk aversion, a distrust of conventional investment model portfolios, and a greater emphasis on surviving as opposed to thriving. If valid, then an investor or an investment committee would likely stress the bird in the hand – as opposed to the one in the bush; stable and secure income – as opposed to uncertain capital gains; a government-regulated utility model – as opposed to innovative yet risky venture capital investments. At current price levels, to cite one example, the current income from corporate bonds is higher and certainly more secure than the dividend income from stocks.2 A return to an era reminiscent of the first half of the 20th century is not unimaginable where stocks were viewed as subordinated income producers with yields exceeding their senior bond companions on the liability ladder.

 But let me not go too far in suggesting that asset classes near the perimeter of risk have no future. They do if only because they eventually will be priced right. In fact, PIMCO intends to participate in the management of many of them, and as argued previously should be well and healthily positioned to do so. Our recent launch of a global multi-asset fund featuring tail-risk protection is just one example. The potential participation in TALF and other government-sponsored levered structures is another. Still, the tide seems to be going out and as Buffet suggests, all swimmers are being exposed, swimming suits or bare-bottomed naked.

 There are a host of investment implications that one can subjectively conclude from this outgoing tide, although they have not been officially endorsed by our upcoming secular forum. It seems to me, though, that one has only to ask what investments were positively affected by the previous long-term cycle of levering, deregulation, and globalization in order to imagine which ones will do poorly as the trends reverse. A short list might read as follows:

 (1) The Dollar – As the center of structured finance and the shadow banking system, the dollar was bolstered as it sold paper to the rest of the world. To date, its recent strength seems counterintuitive. Weakness may more accurately describe its future.

 (2) Credit – Lax regulation and increasing leverage squeezed risk premiums and spreads to historically overvalued levels. We are now moving in full reverse.

 (3) Equity – In addition to the previous conclusions, it is evident in retrospect that narrow risk premiums in credit markets facilitated narrow equity premiums in stocks if only because they seemed cheap by comparison and allowed corporations to borrow cheaply and buy back their own stock.

 (4) Emerging Market Globalization and lax lending standards re-rated emerging and developing country financial markets to unrealistic levels. Eastern Europe is likely the first to fall.

 Many of these trends, of course, have now reversed course, direction, and magnitude, and there will come a point where those low and lower prices, as well as the potential for successful policy healing, will favor what is now in disfavor. For now, however, let it be simplistically said that the trend is your friend and that the ad hoc, disjointed and anemic policy responses of government appear to be too little, too late. Investors should therefore favor stable income as opposed to speculative growth or the subordinate liability structures of most private market balance sheets. Shake hands with the government is and has been our motto although the contractual certainty of a government handshake may now be questioned in an increasingly number of marginal areas.

 Another way to summarize our caution would be to quote a recent comment by Barton Biggs. “I am a child of the bull market,” he said which upon further elaboration meant that he bought on cyclical dips with the expectation of riding mean reversion to an upward sloping trend line of prosperity and ultimately higher peaks. In a sense, we are all children of the bull market, although some of us are more mature than others – a bull market of free-enterprise productivity and innovation, yes, but one fostered by a bull market in leverage, deregulation and globalization that proved unsustainable in its excesses. We now must view ourselves as chastened adults, forced into acknowledging a new reality that is dependent upon bear-market delevering and debt liquidation to deliver us to our new and ultimate restructured destination – wherever it lies. Thus, while historians might describe these years as an evolution, for those of us living it day-by-day it most assuredly has the feel of a revolution. Much like Irving Fisher’s “permanently higher plateau” of prosperity that was quickly turned on its head in 1929, those who would forecast a “permanently lower valley” of despair might similarly be off the mark. Yet there should be no doubt that the bull markets as we’ve known them are over and that the revolution is on. Investing is no longer child’s play.

Bill Gross, CIO PIMCO
 

Improvement in the U.S. economy, whenever it comes, will be much weaker than recoveries from previous downturns, the founder of giant bond-fund manager Pacific Investment Management Co. said Friday.

Bill Gross, who is also Pimco’s co-chief investment officer, told CNBC that anyone expecting a robust uptick on the back of consumer spending ought to brace for a “new normal that in no way resembles past experience.”

“Those who would look for bottoms in the economy or the stock market, I think, are really focusing on the wrong thing, because that implies that we’re going to return to what is a normal stasis,” he said.

The “new normal” will likely see U.S. unemployment — now at a quarter-century high of 8.5% — reach 10% before it retreats to 8%, not 4%, Gross said. The economy, he added, will bottom before starting to grow at a modest 1% to 2%, not the 3%-4% of historical norms.

“We’re evolving into a post-levered financial economy which will witness intense regulation and a redistribution of profits and wealth, most importantly, to previously disadvantaged groups,” he said.

Gross said he believes the U.S. will show signs of recovery starting in the second half of this year, with the key driver being government stimulus spending.

Dow Jones Newswires

NEW YORK — A big cash pillow is something investors, especially retirees, can sleep on these days — once they’ve filled it.

Experts recommend stashing away at least a year’s worth of expenses in easily accessible cash, along with several years worth of bonds prior to retirement. That allows investors to draw down those assets instead of selling equities if the market is down

“Although it’s not a guarantee, there’s a pretty good probability that five years from now stocks will be higher,” says John Smartt, a financial adviser in Knoxville, Tenn.

The question becomes: How does someone build up this cushion without looting their existing investments? The answer is to make savings a big priority over spending.

For those who already have six months of cash savings, as was recommended before the downturn, the change may not be as drastic as for those who have less.

How drastic? No new cars, no big-ticket purchases, even no vacations until enough cash has been shoveled away, especially in the current economy. All the money that is saved should go to cash savings.

“This should take precedent over other savings goals,” says Patrick Collins, a financial adviser in Towson, Md. He likens it to filling a glass of water: Only what flows over can go into other investments.

He says it’s not unusual for clients earning more than $500,000 a year not to have a cash cushion if they have other assets. They don’t think about the high cost of cracking the 401(k) early or selling real estate or stock in an emergency.

If one of his clients is close to retirement without cash reserves, Collins will gradually sell the client’s assets to rebalance the portfolio. For example, if the portfolio has 80% equities, he’ll sell off over several months some of the stock so that it has about 60% equities.

If investors are still working, they should increase their savings or temporarily suspend or lower 401(k) contributions to the level of the company match. (Getting the company match should remain a priority, since the returns are instant and substantial.)

This emergency cash should be in an easily accessible account, typically an FDIC-insured bank account or money market. Unless someone has lots of extra cash, it shouldn’t be put it into laddered CDs because the money needs to be readily available without penalties.

“Safety is much more important than returns on that pot of money,” says Collins.

In addition to the cash, advisers recommend that retirees have enough savings in a bond fund to cover several years of expenses. The fund should include Treasurys, corporate bonds and agency bonds. Again the goal isn’t a big return, it’s dependability.

Investors ideally should begin saving in a diversified bond fund 10 or 20 years prior to retirement.

The additional cash and bonds could grow either in or outside of a 401(k) or individual retirement account — as long as the investor won’t need the money before they’re 59 and a half or they’ll face penalties on withdrawals.

They’re not “ironclad,” warns Morningstar mutual fund analyst Michael Herbst. The investment-grade bond market suffered in late 2008 after the collapse of investment bank Lehman Brothers Holdings Inc. (LEHMQ).

But Herbst and others still recommend the Vanguard Short-Term Investment Grade (VFSTX) as a good option despite last year’s 4% loss.

“It’s solid,” Herbst says, “And the fees are extremely low at 21 basis points.”

By Jilian Mincer
A DOW JONES NEWSWIRES COLUMN

The handful of U.S. bond-fund managers who avoided last year’s market bloodbath by hiding out in Treasurys now say they favor owning corporate and mortgage bonds and selling U.S. government debt.

PIMCO, Vanguard, Morgan Stanley and First Pacific Advisors funds that gained from about 5% to a stunning 49% while the Standard & Poor’s 500 stock index plunged 37% last year are inclined to take a bit more risk.

They’re sticking to mortgage-related debt and other bonds supported by the Treasury or the Federal Reserve. And they are cautiously buying corporate bonds.

“Investment-grade credit is very attractive,” said Gregory Davis, head of bond indexing at Vanguard and portfolio manager for its Long-Term Bond Index Fund (VBLTX). The fund gained 8.6% in 2008, making it one of the top-performing U.S. bond funds last year, according to investment researcher Morningstar Inc.

For corporate bonds, “a lot of bad news is priced in, including defaults and downgrades,” Davis said.

Top-performing fund managers are selling or paring their holdings of U.S. Treasurys, one of last year’s best-performing assets. The $2 trillion in new bonds the Treasury is expected to issue this year will likely weigh on prices.

Meanwhile, other government programs to bail out the credit markets, say by guaranteeing bank debt, will make Treasurys less attractive, managers say.

“As policy maneuvers are implemented and make the way through the system, prudent investment managers are going to be reducing their risk-free exposure and going more towards risk products,” meaning anything besides Treasurys, said Steve Rodosky, manager of PIMCO Long Duration Total Return Fund (PLRIX), which gained 12.4% last year.

By comparison, the Barclays Capital U.S. Aggregate Bond Index rose 5.24% in 2008. A wide range of bond funds took huge losses as volatility and illiquidity in credit markets made trading dicey, and investors fled most assets in favor of the safety of Treasurys — slamming holdings in corporate debt, mortgages and even municipal bonds.

If more investors follow these managers’ strategy into corporate debt and mortgages and out of Treasurys, the government will end up paying more to finance its growing deficit. And investors who have hung onto Treasurys bought in the current rally could see their portfolios take a nosedive.

Copying The Fed

One strategy that successful managers say has some legs is to buy debt that the government is also buying.

That strategy lends itself to holding mortgage-backed securities and debt sold by the big housing finance agencies including Fannie Mae (FNM), Freddie Mac (FRE), Ginnie Mae and the Federal Home Loan Banks.

The Fed has purchased $24.6 billion in agency debt since December, and aims to buy up to $100 billion, in the hope of lowering mortgage rates and reviving the housing market.

First Pacific Advisors’ New Income Fund (FPNIX), which rose 4.8% last year, is keeping the biggest chunk of its cash in mortgage-backed securities.

Thomas Atteberry, who helps run the fund and was named Morningstar’s fixed-income manager of the year for 2008, plans to keep that segment around 42% of the fund. He also has about 20% of the fund in agency debt. Both benefit from having the Fed as a major buyer, in addition to the government taking over Fannie and Freddie last year, effectively guaranteeing those entities.

“The Fed will keep those capitalized because it needs the institutions to implement policies in the mortgage space,” Atteberry said.

Companies that are explicitly benefiting from policy actions are likely to have the best opportunities, said Rodosky, who also manages the PIMCO Extended Duration Fund (PEDIX). That fund gained 49% last year, predominantly by holding Treasury and agency zero-coupon bonds that perform well in a declining rate environment, he said.

Debt sold by banks that is guaranteed by the Federal Deposit Insurance Corp. should do well, he said.

Also, debt sold by firms that have issued FDIC-backed notes but trade on their own rating have good potential relative to the risk involved, he said.

Goldman Sachs Group Inc. (GS), Citigroup Inc. (C) and Morgan Stanley (MS) have issued FDIC-backed bonds.

Still, “there are going to be some losers in this process, despite the government guarantees,” he said. Several institutions are likely to be consolidated.

“Not every bond out there is money good,” he said.

Company Debt Looking Better

Several managers recommended investment-grade debt, rated at least Baa by Moody’s Investors Service or BBB by Standard & Poor’s, saying the yield compared to benchmark Treasurys is advantageous.

Corporate bonds rated A or higher carry yields 4.66 percentage points over Treasurys, according to an index compiled by Merrill Lynch. That spread skyrocketed to as much as 5.90 points in early December, after generally being below 1.5 points until late 2007.

Wide spreads mean there’s a good opportunity for those bonds to improve as the gap narrows, Vanguard’s Davis said.

“If we see even a stabilizing economy, we can see outperformance in this sector,” he said.

Part of Vanguard’s gains can be attributed to engaging in less trading than more actively-managed funds, because it’s designed to match the characteristics of the Barclays Capital U.S. Government/Credit Bond Index, Davis said.

That Barclays index rose 5.7% in 2008.

In matching the index, the fund’s biggest holdings include General Electric Co. (GE) and AT&T Inc. (T).

GE’s bonds, rated AAA, sold off sharply last year as a broader crisis of confidence led investors to demand higher yields on all company debt, but ended 2008 much closer to where they started.

David Armstrong, who helps oversee the Morgan Stanley Long Duration Fixed Income Fund (MSFIX), also has focused on companies that have conservative operating and financial leverage and are able to withstand a severe recession.

“It is hard to judge the depth and duration of the economic contraction so we are concentrating on credit quality,” Armstrong said.

The fund returned 10.9% in 2008. It started last year with about 30% in corporate bonds, less than its benchmark, anticipating more weakness in the economy than many others were positioned for. The fund is now up to 45% in company debt, largely through the addition of high-quality industrial names, he said.

He noted a number of high-quality issuers have issued debt recently, including Wal-Mart Stores Inc.(WMT), McDonald’s Corp. (MCD) and Emerson Electric Co. (EMR).

Treasury Rally Over

Bond managers expressed the most distaste for Treasurys, which helped several avoid the market’s pitfalls last year. They expect Treasury bond prices to fall, pushing yields up, hurt by the same policies that help other assets. The government is incurring a lot of debt by buying other securities and propping up financial markets, let alone the massive economic stimulus package expected to be approved in the next month or so.

“We’re going to see rates back up on the longer-dated paper,” Davis said. “There is a lot of supply to be digested.”

Still, uncertainty about the economic outlook for 2009 has First Pacific Advisors’ Atteberry cautious.

Enough policy questions remain to keep him from aggressively adding to holdings he already had.

For example, legislation to amend bankruptcy laws to allow judges to change mortgage terms could wreak havoc for the mortgage market, where investors focus intently on how long a given mortgage will be outstanding or be refunded.

Also, speculation that the government wants to help a lot of home purchasers lock in mortgage rates close to 4.50% for 30 years means those owners will have little incentive to move, also affecting how long a mortgage will actually be outstanding, Atteberry said.

“These are fundamental changes to the rules of the mortgage space, so prudence tells you to back away,” he said.

Reflecting that view, the fund has about 31% in cash or cash equivalents, he said.

“There are a lot of policy moves and I think people should wait and see what the rule changes look like,” Atteberry said.

By Deborah Levine

 WASHINGTON — U.S. consumer prices barely rose last year by their slowest pace in over a half century, a government report showed, a stunning turn just a few months after inflation hit 17-year highs.

Much of the reversal was due to a roughly 75% decline in oil prices from their July peak that has in turn brought prices down for everything from gasoline and home heating to airline fares.

But some of inflation’s disappearance is also a consequence of the severe economic recession that is causing nervous households to delay spending, which in its worst form could lead to the type of deflationary spiral that gripped Japan in the 1990s.

The consumer price index dropped 0.7% in December on a seasonally adjusted basis compared to the previous month, the Labor Department said Friday, after falling at a record pace in November. Economists had expected a 0.8% decline.

The core CPI was unchanged. Economists had expected a slight rise.

Unrounded, the CPI fell by 0.737% last month, the fifth drop in a row. The core CPI fell 0.015% unrounded.

Consumer prices rose just 0.1% compared to December 2007, the lowest calendar-year increase since 1954 and well below the Fed’s 1.5% to 2% preference over the long run. The CPI swelled 4.1% in 2007. The core CPI, in contrast, was up 1.8% last year, though it did fall 0.3% on an annual basis during the fourth quarter.

Federal Reserve officials have in recent days downplayed the chances of deflation, though they’ve also said inflation should moderate further. “It seems likely that inflation will move, for a time, below levels that are consistent with price stability,” San Francisco Fed President Janet Yellen said Thursday, though she said she is confident any deflationary forces can be contained.

Some Wall Street economists think changes in the CPI will soon turn negative on an annual basis given the weakness of the economy and the sharp increases that occurred in early 2008.

“We will have to wait a further month before we get headline deflation,” said ING Bank economist Rob Carnell, in a note to clients. “But it is coming and may get down to as low as -3%” on an annual basis unless oil prices reverse their recent declines, he said.

As long as price declines stay centered in energy and commodities, it’s largely a plus for the U.S., especially since it imports most of its oil from abroad. It’s when those declines get embedded more broadly in inflation expectations and cause consumers and business already facing a weak economy to delay spending, hiring and production that they become an economic headache.

And there are early signs that may be occurring. Industrial production fell 2% on a monthly basis in December, the Fed said, almost double the decline economists had expected. Nearly all categories in the report, from technology to cars to clothes, showed falling output, pushing the capacity utilization rate to well below its hitorical average.

“The manufacturing sector is mired in very deep recession,” Insight Economics analyst Steven Wood said.

The Fed has already lowered rates to near zero to prevent a deflationary spiral from occurring. The CPI data give the Fed even more latitude to use its balance sheet to stabilize the financial system without worrying about the inflationary effects.

The recent plunge in price pressures has also breathed new life into the once-dormant inflation targeting debate. In the minutes of their December meeting, Fed officials said an explicit inflation objective “might help forestall the development of expectations that inflation would decline below desired levels.”

According to Friday’s report, energy prices tumbled another 8.3% in December compared to November and plunged 21.3% for 2008 as a whole, the largest annual decline ever. Gasoline prices plummeted 17.2%.

Food prices slid 0.1%. Food and beverage prices were flat.

Transportation prices fell for a third month in a row, by 4.4%, as airline fares dropped 1.2%. New vehicle prices fell 0.4% in December and 3.2% for 2008 as a whole, the biggest drop since 1971, reflecting the severe slump in auto sales.

Housing, which accounts for 40% of the CPI index, was unchanged. Rent increased 0.2%. Owners’ equivalent rent advanced 0.1%. However household fuels and utilities prices tumbled 0.5% while lodging away from home fell by 0.7% as households cut back on non-essential spending. Recreation, another discretionary item, also fell in price.

Medical care prices increased 0.3%, while clothing prices fell 0.9%, which may reflect holiday discounting that the most recent Fed Beige Book called “sizable.”

In a separate report, the Labor Department said the average weekly earnings of U.S. workers, adjusted for inflation, climbed 0.6% in December as higher wages and falling prices offset a decline in hours worked.

By Brian Blackstone
Of DOW JONES NEWSWIRES

WASHINGTON — U.S. Federal Reserve officials on Tuesday slashed official interest rates to an historic low range to combat a deepening recession and signaled they will keep rates “exceptionally low” for some time amid rapidly waning price pressures.

Officials also signaled a new phase for policy in which lending programs financed by the Fed’s ballooning balance sheet, a process known as quantitative easing, replace the federal funds rate as the Fed’s primary policy tool.

The Federal Open Market Committee voted unanimously to reduce the target fed funds rate for interbank lending from 1% to a range of zero to 0.25%, the lowest since the Fed started publishing the funds target in 1990. The market-determined effective fed funds rate already has already hit record lows in recent weeks.

Economists had expected a smaller cut of just 0.5 percentage point, and hadn’t envisioned the Fed setting a range.

“The Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time,” the Fed said, adding it will “employ all available tools” to promote growth and maintain price stability.

The Fed has used a variety of operating targets through the decades, including the discount rate and monetary aggregates.

The Fed also lowered the discount rate paid by commercial and investment banks for Fed loans by 0.75 percentage point to 0.5%.

In a statement, the FOMC said its focus “will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level.”

Ben Bernanke tipped the shift toward quantitative easing — in which cash is essentially created and used to finance lending facilities — earlier this month. He said that while the Fed’s ability to use interest rates to support the economy “is obviously limited” with rates so low, the “second arrow in the Federal Reserve’s quiver — the provision of liquidity — remains effective.”

Even President-elect Barack Obama on Tuesday said “we are running out of the traditional ammunition that’s used in a recession, which is to lower interest rates, they’re getting to be about as low as they can go.”

The Fed already has nontraditional initiatives in place to support lending to commercial and investment banks, provide U.S. dollar funding overseas and stabilize commercial paper and money market mutual funds. The Fed recently started purchasing agency debt and has announced plans to purchase hundreds of billions of dollars of agency-backed mortgage backed securities and consumer-linked asset backed securities.

In Tuesday’s statement, the Fed also said it is “evaluating the potential benefits of purchasing longer-term Treasury securities.”

When loans to Bear Stearns and American International Group are included, the Fed’s balance sheet now tops $2.2 trillion, more than double where it was when Lehman Brothers collapsed in mid September.

Meanwhile, the drumbeat of economic news worsened considerably between the late October and December FOMC meetings, highlighting the need for more stimulus. Consumer spending got off to a horrible start in the fourth quarter, and the economy lost more than 500,000 jobs in November alone, a total that could be matched or exceeded this month.

On Dec. 1 the National Bureau of Economic Research, the semi-official arbiter of recession, declared that the U.S. has been in a recession since last December. And it appears to be getting worse. Wall Street economists expect U.S. gross domestic product to plunge as much as 6% at an annual rate or even more this quarter. Some are penciling in another steep drop for the first quarter of 2009.

“The outlook for economic activity has weakened further,” the Fed said, noting weak labor markets and declining consumer spending, production and investment.

That weakness, coupled with a steep declines in energy prices, has not only brought inflation rates down sharply but also fanned some fears of outright deflation — which is a sustained, economy-wide decline in prices that cripples consumer and business spending. In its worst form, deflation is associated with Japan’s deep recession earlier this decade as well as the Great Depression.

According to November consumer price data released Tuesday, annual U.S. inflation is now running just 1.1%, matching its lowest rate since 1965. If December data come in soft as expected, the annual rate could approach zero.

“Inflationary pressures have diminished appreciably,” the Fed said, citing lower energy prices and the weak economy.

Still, Fed officials didn’t go as far as they did in 2003, when they referred in policy statements to the risk of an “unwelcome fall” in inflation.

Officials have good reason to avoid such language for now. Outside of energy and energy-dependent sectors, prices are still rising albeit at a slower pace then they were a few months ago.

And the Fed’s deflation fears in 2003 and 2004 appear in hindsight to have been overblown and may even have contributed to ultra-low interest rates that fueled the housing bubble.

By Brian Blackstone andMaya Jackson Randall
Of DOW JONES NEWSWIRES

WASHINGTON — U.S. Federal Reserve Chairman Ben Bernanke on Monday signaled that officials will hold nothing back in their support of financial markets and the economy, calling further interest rate cuts from already low levels “certainly feasible.”

In prepared remarks to an economic conference in Texas, Bernanke also said the Fed’s powers don’t end with the federal funds rate, and its ability to inject liquidity into markets through its balance sheet “remains effective.”

While officials will at some point need to bring short-term interest rates and liquidity back to more sustainable levels, “that is an issue for the future,” Bernanke said in the text of his remarks to the conference in Austin, Texas.

“For now, the goal of policy must be to support financial markets and the economy,” Bernanke said.

Among the Fed’s options, Bernanke said, are direct purchases of Treasurys and securities issued by government-sponsored enterprises “in substantial quantities” to affect yields, “thus helping to spur aggregate demand.”

He cited the Fed’s announcement last week that it will buy up to $600 billion in GSE debt and GSE-backed mortgage securities and called it “encouraging” that the announcement of that measure has brought mortgage rates down.

The Fed can also channel liquidity to certain segments of the financial markets, Bernanke said, citing the Fed’s recent measures to support the commercial paper market.

Bernanke said the U.S. economy “remains under considerable stress” and that after contracting 0.5% at an annual rate in the third quarter, “economic activity appears to have downshifted” after September.

Reflecting that assessment, the Institute for Supply Management’s November manufacturing index, released Monday, fell to its lowest level since 1982. Meanwhile, construction spending posted a steeper-than-expected drop in October, according to government figures. The November employment report, due for release Friday, is expected to show a plunge in nonfarm payrolls in excess of 300,000 with a further increase in the unemployment rate.

Indeed, Bernanke said weekly jobless claims figures “suggest that labor market conditions worsened further in November.” And with labor and credit conditions worsening, consumer spending is “on a pace to post another sharp decline in the fourth quarter,” he said.

The National Bureau of Economic Research, an academic group that determines when recessions occur based on a series of indicators, on Monday officially declared that the U.S. is in fact in a recession that began last December.

To prevent a deeper and prolonged recession, Fed officials are expected to lower interest rates at their Dec. 15-16 policy meeting, a view supported by Bernanke’s remarks Monday.

The target federal funds rate already sits at just 1%, matching lows last seen in 2003 and 2004. Further cuts would put the funds rate at levels not seen in a half-century.

Yet, even if the fed funds rate approaches zero — as a growing chorus of Wall Street economists expect — the Fed still has considerable sway over markets and the economy through its balance sheet.

“Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve’s quiver — the provision of liquidity — remains effective,” Bernanke said.

That firepower was evidenced last week by the Fed’s decision to provide a loan backstop for the government’s bailout of Citigroup Inc. (C) and purchase GSE and GSE-backed mortgage securities.

Bernanke pledged that the Fed and other financial market regulators “will carefully monitor the conditions of all key financial institutions and stand ready to act as needed to preserve their viability in this difficult financial environment.”

However, he cautioned that government officials will have to at some point make dealing with the too-big-to-fail issue “a top priority.”

Bernanke was upbeat on the outlook for inflation, saying that with commodity prices down “dramatically,” inflation “appears set to decline significantly over the next year toward levels consistent with price stability.”

By Brian Blackstone
Of DOW JONES NEWSWIRES