It's a bond picker's market. Beware of corporate releveraging.
Michael Roberge, chief fixed income officer at
Boston's MFS Investment Management, thinks investors have a good chance
of seeing decent returns from certain pockets of the bond market this
year. But they need to pick their spots carefully.
"It's a security by security analysis that's going
to matter in the market over the next year or two," he says. "The name
of the game in fixed income now is owning the market but avoiding the
mistakes."
From Roberge's perspective, investors have ample
reason to keep bond money in play even as interest rates on
intermediate- and long-term fixed income investments look poised to
follow the rising trend at the shorter end of the yield curve. "There's
not much yield in the equity markets, and people who are looking for
income from their investments don't have a lot of options," he says.
"Besides, almost everyone expected bond rates to climb last year, and
they didn't."
The bond market in 2004 indeed defied expectations
by posting gains even after several interest rate hikes from the
Federal Reserve. In a year that many predicted would be marked by
negative returns for fixed-income investments, the average U.S. taxable
bond fund returned 4.54%, according to Lipper. High-yield and world
income funds did even better, posting returns of 9.89% and 9.84%,
respectively. Even U.S. Treasury securities defied predictions of price
erosion, with the yield of the ten-year benchmark ending the year about
where it began. A number of factors, including strong participation by
foreign investors in the U.S. bond market, helped keep bond prices
stable.
But this year presents a new set of challenges that
could make foreign investors more skittish about investing in U.S.
bonds, says MFS Chief Investment Strategist James Swanson. In a recent
market commentary, Swanson noted that U.S. Treasury prices "have the
potential to be strongly affected by dollar weakness because a
significant part of the Treasury market is comprised of
non-dollar-denominated investors." And with the U.S. savings rate near
zero, compared to 10% of disposable income two decades ago, "overseas
investors are financing most of the federal deficit." Those investors
are becoming increasingly concerned that the growing U.S. budget
deficit will erode the country's economic health, and rates may need to
rise to attract these offshore buyers.
Still, Roberge thinks that while rates may trend
higher, the climb will not be substantial. He sees the Fed Funds rate
increasing to 3% over the next 18 months, and a rate of around 5% to
5.25% for ten-year Treasury bond within three to six months. He
believes the fund's benchmark, the Lehman Brothers Aggregate Bond
Index, may be able to "eek out a positive total return this year. But
it will be a close call."
Another problem is that the slim difference in yield
between Treasury issues and corporate bonds makes it more difficult for
investors in the latter type of securities to realize capital gains
from narrowing spreads. Recently, high-quality corporate bonds yielded
only about 80 basis points more than ten-year Treasuries, he says,
while high-yield "junk" bonds beat Treasury bond yields by about three
percentage points.
"If you look at the high-grade market from November
of 1991 all the way to 1998, the spread was tighter and basically
didn't move for seven years," he says. "The reason is that we are in a
business expansion. We are probably in that type of environment over
the next several years, so we expect spreads to remain tight."
Roberge thinks that spreads between high-yield bonds
and Treasuries have enough room to narrow a bit more this year, and
that in a rising rate environment corporate bonds will likely
outperform interest-rate-sensitive Treasuries. "The place to find value
in fixed income is the corporate credit markets because of the
fundamental improvement we are seeing," he says. "Companies have record
levels of cash on the balance sheet and high levels of interest payment
coverage, providing solid underpinnings to these markets."
As the head of the team that manages the MFS
Research Bond fund, an intermediate-term investment grade offering,
Roberge needs to keep a significant portion of the fund in Treasury
notes, agency securities, and mortgage-backed bonds to maintain the
portfolio's average credit quality at a high investment grade level of
AA-. He also keeps the fund's duration neutral relative to its
benchmark. Currently, the fund and the benchmark have durations of
four-and-a-half years.
Roberge relies on credit analysis, rather than
interest rate adjustments, to boost returns. He also has leeway to
overweight or underweight corporate bonds and other non-U.S. government
securities relative to the index. Since its inception in 1999, the fund
has outperformed the Lehman Brothers Index and its Morningstar
intermediate-term bond fund category average for five out of six
calendar years. Its three- and five-year annualized yields are in the
top 6% and 3%, respectively, for the group.
The fund's current sector stance reflects a
conviction that corporate bonds will outperform government issues this
year. Recently, the portfolio had about half of its assets in
Treasuries and government securities, including agency issues and
mortgage-backed bonds, compared to about 70 % in such securities for
the Lehman Index.
Companies at the higher-quality end of the junk bond
spectrum that are on the cusp of receiving a credit upgrade from the
major bond rating agencies are of particular interest. When that
happens the prices of those bonds often get a boost, because pension
funds and other institutional buyers that have credit quality
restrictions can buy them.
Two years ago, the fund used this strategy by buying
Tyco bonds soon after the company's management problems made headlines.
Convinced that Tyco had ample asset coverage and generated sufficient
cash flow to meet its debt obligations, Roberge moved in after the
stock dropped substantially and the bonds were downgraded from an A
rating to below investment grade. Last year, the major rating agencies
upgraded Tyco to a low investment grade rating and the bonds responded
favorably. Another long-time holding, bathroom and kitchen fixture
maker American Standard, crossed into investment grade territory last
year after it shored up its balance sheet and paid down debt.
To select securities that are good candidates for an
upgrade, Roberge and his team of analysts look for companies that have
a proven management team, competitive positioning in the marketplace
and strong free cash flow. They also like to see strong indenture
provisions and solid collateral.
While free cash flow is usually a plus, Roberge
cautions that some companies are using it to benefit stockholders at
the expense of bondholders. "With companies awash in cash, the bad news
in the credit markets is the growing pressure by stockholders to add
debt to buy back stock and implement dividends," he says. "We've seen
examples recently of companies sacrificing their investment-grade
rating by adding debt to their balance sheets and becoming a junk
company to do a share buyback."
He cites former fund holding HCA as one company that
took such a route when it decided to take on a significant amount of
debt last year in order to proceed with a share buyback. With a sizable
chunk of leverage added to its balance sheet, the rating agencies
downgraded the hospital and health care facility holding company's
bonds. On the other hand, fund holding TXU Corp., a Texas utility, used
leverage in a share buyback but still managed to keep its balance sheet
healthy and avoid a credit downgrade.
"We understand that equity holders provide capital,
but companies need to balance their interests with those of debt
holders," he says. "TXU has done that."
While MFS Research Bond fund also owns a sprinkling
of emerging market debt to perk up returns, Roberge believes investors
will need to modify their expectations for the sector this year.
"In 2002, when we saw a deterioration of corporate credit quality in
the U.S., the credit quality of the emerging market countries was
improving," he notes. "With political reforms and corporate
restructuring, about half of the emerging market bond index is now
investment grade. There's been enormous appreciation in this category,
but we won't be seeing that over the next couple of years." Still, with
emerging market debt yielding about 400 basis points over Treasuries
and potential for further credit improvement over the next decade, he
believes the asset class remains "relatively attractive."