By Deborah Levine

NEW YORK (Dow Jones) -- 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 (SPX) 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 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). It 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 deficits. 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 worth, in the hopes 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 that trade on their own rating have good potential relative to the risk involved, he said.

Goldman Sachs (GS), Citigroup (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 its yields 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 it started it.

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 (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, by the same policies that help other assets. The government is incurring a lot of debt 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."

Ten-year notes (UST10Y) yield 2.73%, up from a record low of 2.04% on Dec. 18.

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 change bankruptcy laws to allow judged 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, the 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.

A reflection of 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.

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