(MONEY Magazine) – For a man generally regarded as the top bond fund manager of his generation, Bill Gross, 53, chooses a rather unflattering metaphor to describe fixed-income buyers. "Bond investors are the vampires of the investment world," he says. "They love decay, recession--anything that leads to low inflation." (Inflation, of course, is the bane of the bond market, since it drives up interest rates and thus drives down bond prices.) Lately, bond investors have been desperate for bad news. The economy has been growing more or less steadily for six years, unemployment has declined by more than two percentage points since 1992 to 5.3% and the consumer-confidence index has more than doubled. Not surprisingly, bond returns have lagged behind the S&P 500, 8.5% to 17.5%.

Gross says all that is about to change. In his book Everything You've Heard About Investing Is Wrong! (Times Business, $24), the co-founder of Pacific Investment Management and manager of the PIMCo mutual funds argues that double-digit returns from stocks are coming to an end and that bonds figure to be much more attractive investments for the next three years. (For more on the same theme, see the story that begins on page 78.) Nonetheless, he reassures investors that they are not heading into the night of the living dead.

Q.With the stock market doing so well, what is the argument for buying bonds?

A.Because people have put so much in stocks already. A portfolio should balance the risk inherent in each security, but for many investors the teeter-totter is weighted all the way on the stock side. Sooner or later--and more likely sooner--there will be a correction in stocks, and investors will bear the full brunt of it.

Q.So is this a good time to buy bonds?

A.Absolutely! The best I can forecast for stocks is an 8% total return. Dividends provide 2%, and the rest is earnings growth--which you may or may not get. Bonds currently yield a reliable 7%, with the possibility of something more if rates decline as I predict they will. That stacks up pretty well against stocks.

Q.What kind of stock market correction do you foresee?

A.I believe it will be less than 10%. Just think, stocks gained about that much in just the first two months of this year. But frankly, that's as much as they're going to gain all year. We already saw the peak, and the correction will keep stocks flat for 1997 as a whole.

Q.So why not buy stocks on the next dip?

A.Because you won't get rewarded for it. At today's high prices, stock investors will have to adjust their sights to 6% annual average price appreciation over the next three years. That means they'll be waiting a lot longer to earn back money lost in dips.

Q.What's going to happen in the next three years to make your scenario come true?

A.The economy will grow more slowly at 1% to 2% a year, compared with the current 2.5% to 3%. This will happen as the strengthening dollar limits exports and consumers cut back on spending because they have already accumulated too much debt. Inflation will be lower, not higher, because oil prices are declining, and U.S. manufacturers, faced with more competition from imports--the flip side of the strong dollar--won't be able to raise prices.

Q.What about interest rates?

A.I see rates declining very gradually. Right now, the 30-year Treasury bond is yielding about 7%, and by year-end I think it will be close to 6.25%. True, Federal Reserve chairman Alan Greenspan has raised short-term rates one-quarter of one percentage point. But the economy will weaken, and I think Greenspan will discover that boosting rates was such a mistake, he'll end up having to lower them again by early 1998.

Overall, I think we are in an environment where long-term bonds will yield from 5% to 7%. The pressures of globalization will cap the upper end. The prime component of inflation is wages, and global competition is limiting wage increases. So interest rates can't go much higher than 7%. For them to fall below 5%, on the other hand, the economy would have to be running at zero inflation or deflation--which I don't think is a strong probability.

Q.How much of our readers' portfolios should be in bonds?

A.Of course, allocations should be made according to a person's ability to stomach risk. But for investors in their forties and fifties, I recommend an overall split of 70% in stocks and 30% in bonds. I'd break down the bond portion as follows: 40% in Treasuries that mature in five to 10 years, 25% in corporate debt of the same maturities, 25% in mortgage-backed securities like Ginnie Maes and Fannie Maes and 10% in foreign government issues.

I think inflation is going to cool, but if you don't and you want to protect yourself against it, you could put the whole 30% into the new inflation-indexed Treasury bonds. They're the deodorants of the bond world: They take the worry out of your day. Not only are the bonds guaranteed against default, but they promise that you'll always earn a rate of interest above the rate of inflation. Right now, they're paying a 3.3% return after inflation. That's attractive for such a secure investment.

Q.If bonds are so promising, why would you put only 30% of your portfolio in them?

A.Because over the long term, stocks return more than bonds. That said, however, for the rest of 1997 I would suggest 50% in bonds and 50% in stocks. If stock prices have peaked as I think they have, the only money investors will see is 2% from dividends. You can earn three times that in bonds.

Q.Should investors buy individual bonds?

A.If you have less than six figures to invest--and you won't be surprised to hear a bond fund manager say this--buy funds.

The things to consider before you invest are the return, obviously, but also fees and maturity. When you're looking at single-digit returns, fees can take a big chunk out of your income. So don't pay any more than 0.5%. Extend your maturities to pick up additional yield. If you are already in a bond fund with a five-year maturity, switch to a seven- to eight-year one. And if you have a 10-year average maturity, then go out to 13 or 14 years. If you've never invested in bonds, take the money you have in a money-market or savings account and put it in a short-term fund that invests in two- to three-year notes. You won't add much risk, and you'll earn 1.5 percentage points more than you'd get in a money market.

Q.You seem to like mortgage-backed bonds. What makes them so appealing?

A.Several things. They are usually AAA- or AA-rated securities, and they have implicit government protection against default. Plus their yields--typically 7.5% to 8%--are very attractive with inflation at 2% to 3%. I'd recommend buying them in a fund like the Vanguard Fixed Income GNMA fund (no load; 7.13% three-year annualized return; 800-851-4999). Vanguard has the lowest fees in the industry and is well managed. (PIMCo is close on fees, but we don't have a Ginnie Mae fund.)

Q.What kind of international debt should investors be looking at?

A.Put your money in emerging market bond funds. Here's why: Many international funds are not completely hedged in U.S. dollars. So when the dollar is as strong as it is now, the unhedged funds suffer currency losses. But emerging market bond funds are--believe it or not--primarily invested in dollar-denominated Brady bonds. So there's much less currency risk with these funds. Moreover, they hold South American or Eastern European debt yielding 9% to 10%, while German bonds pay 5.5% and Japanese only 2.5%.

PIMCo's Foreign Bond A fund (4.5% load; 11.9% three-year annualized return; 800-426-0107) is a hedged fund. It buys the bonds of countries like Canada and New Zealand, where yields are at U.S. levels or higher. PIMCo is launching an emerging bond fund this June, but if you can't wait, I'd recommend Scudder Emerging Markets Income (no load; 17.31% three-year annualized return; 800-225-2470). I've put members of my own family in it.