January 06, 2009 |
|In a world where 10-year Treasury bonds are yielding around 2.5 percent, many investment pros say that corporate bonds and bond funds yielding 6 percent and up look like good values, even compared with stocks.|
Corporate bonds prices fell hard last year, pushing their yields, which move in the opposite direction, into the stratosphere.
By November, valuations had fallen so low that bargain hunters swooped in. Although they are no longer selling at fire-sale prices, they still look attractive.
"The great deals are gone, but very good deals remain," says Carl Kaufman, manager of the Osterweis Strategic Income Fund.
A popular theory says that because the credit markets started this financial catastrophe, the stock market can't recover until the credit markets do. Therefore, bonds will recover before stocks.
A bond is simply a loan that investors make to a company. The company promises to pay a certain rate of interest each year and when the bond matures, return the original face amount. Even if the company goes bankrupt and its stock becomes worthless, its bonds are usually worth something when the company is liquidated or reorganized.
Corporate bonds rated BBB or higher are called high-grade or investment-grade bonds.
Bonds rated below BBB are known as high-yield or junk bonds. They have a higher risk of default and yield more than high-grade bonds.
Bond fans are divided over which group offers the better value today.
The Dow Jones Corporate Bond Index, which tracks investment-grade bonds of various maturities, is yielding about 7 percent today, down from 8 percent in early December.
Funds that invest in investment-grade, intermediate-term bonds are yielding around 5 to 6.5 percent.
Funds usually yield less than indexes because their managers pay themselves a fee out of the fund's income and keep a portion of their assets in cash, which earns little to nothing. A fund can boost its yield by cutting its expenses, buying lower-rated bonds or buying longer-term bonds. The latter two increase risk.
High-yield bonds, because of their serious default risk, plummeted last year as the economy unraveled. They too have rebounded since early December but are still offering mouthwatering yields.
The Merrill Lynch High Yield Master II Index was yielding more than 22 percent last week. The Merrill Lynch High Yield 100, which includes higher-grade, more liquid junk bonds, is yielding about 14 percent.
High-yield funds are generally yielding 10 to 13 percent, depending on how its measured. They generally don't invest in the junkiest of junk bonds, which limits their yields relative to the broader high-yield indexes.
Jeremy DeGroot, chief investment officer with Litman Gregory Asset Management, says that even if default rates reach Depression-era levels, the annual return from high-yield bonds "would still be in the low to mid teens over a five-year period.
"We are not predicting that high-yield will have an immediate rebound. But if you have a multi-year holding period, the returns we think you can get from high-yield are very attractive relative to equities. And they have less downside risk than equities," he says.
DeGroot's firm is putting 10 to 15 percent of client portfolios in high-yield bonds. Most of that is coming out of stocks.
If the economy were to stage a miraculous recovery, stocks would outperform high-yield bonds. But he sees little chance of that happening.
Among high-yield funds, DeGroot likes T. Rowe High Yield and Pimco High Yield, which are on the more conservative end, and Fidelity High Income, which takes a more aggressive approach.
Martin Fridson, chief executive of Fridson Investment Advisors and a high-yield expert, predicts that high-yield default rates could reach 10 to 12 percent, up from 3 percent today, and that recovery rates - what investors get if the bond defaults - could be lower than normal. Even so, he thinks investors are being compensated for that risk.
"There's no guarantee high-yield (bond prices) won't be lower a month from now. But over a one-year horizon, results should be pretty favorable," he says.
Lawrence Jones, an associate director of fund analysis with Morningstar, prefers investment-grade over high-yield bonds.
"I think high-yield might be one of the last sectors to see improvement. You are talking about companies with large amounts of debt, that are financially stressed. They are going to have trouble accessing credit markets at any level," he says. "With high-quality, investment-grade corporations, you might see them lead stocks out of this malaise."
Among high-grade funds, Jones likes T. Rowe Price Corporate Income and, for longer-term investors, Vanguard Long-Term Investment Grade, which is run by Wellington Management out of Boston. Jones says that investors who want to dabble in high-yield should do so gradually, with no more than 5 to 10 percent of their portfolios.
He adds that investors who own broadly diversified bond funds might already have more corporate exposure than they did last year, as many fund managers have been increasing their stakes in investment-grade bonds.
By Kathleen Pender