The credit crisis has been like a tornado blowing through the bond market, upending the staid order and creating some potential opportunities in certain sectors. Take corporate bonds, for example.
The credit market turned tail in a big way last year after Lehman Brothers was allowed to die, which in turn dumped a lot of bank-debt portfolios onto the market and helped create much-wider-than-normal spreads between Treasury and corporate bond yields-both investment grade and high yield. The spread widened even further as investors sought out Treasurys as a safe haven, further driving down their yield.
Mary Miller, director of fixed income at T. Rowe Price, says the corporate index of investment-grade companies in the Barclays universe of indices was recently about 540 basis points over Treasurys, or an almost 5.5% difference. "There's still a healthy amount of compensation for buying corporate debt," Miller says.
"Investment-grade credit is truly compelling right now, particularly with equities seemingly not able to find a bottom," says Kathleen Gaffney, co-manager of the Loomis Sayles Fixed Income fund.
Gaffney's fund isn't shying away from financials, and it has holdings in some of the bigger money-center banks and higher-quality finance companies. "We believe there will be survivors and key players in that sector," she says.
The Loomis Sayles Fixed Income fund's enviable track record took a beating last year. The portfolio lost nearly 18% and underperformed its benchmark because it had increased its credit exposure as spreads widened. "We expected a slowdown, but not to the depth that occurred last fall," Gaffney says. "We were early in increasing our credit exposure, and the extreme flight to quality caused our underperformance."
But Gaffney believes the fund's moves last year will pay off when the economy eventually recovers. "The high yields on corporate bonds--particularly investment-grade credit--allows us to be very patient while we wait for the recovery," she says. "I've never seen investment-grade corporate bonds trading at these types of discounts in mass. It's been a great buying opportunity and we're looking forward to the upside as the economy improves."
Donald Quigley is co-manager of the Artio Total Return Bond Fund, which has invested roughly 20% in investment-grade corporates. He says the fund is avoiding bank and finance companies because they don't offer much value for their senior debt. "Spreads are wide, so they're cheap on a historical basis," he says. "But we feel the risk of the government coming in and hittingthe debt holders is higher than what the market is pricing in, so why would you want to own their senior debt? We don't think these companies will get their acts together for a long time."
More than 45% of the Payden Core Bond fund's portfolio is invested in domestic corporates, or more than double its benchmark index. "We look around to see if we can exploit things in the marketplace and right now that's the corporate spreads above Treasuries," says fund co-manager Michael Salvay. "We think we can capture those 500 basis point yields and keep them.
"In setting up our overweight to credit, our expectation was that spreads wouldn't come back anytime soon," Salvay continues. "We see this as a multiyear enhancement strategy. In addition, I think we can get some modest price appreciation over a long period."
Salvay's fund is overweight domestic corporate bonds in industries positioned to weather the downturn, such as communications companies--wireless, cable television and the Internet-that he views as consumer staples. It also invests in companies such as Kellogg's, Coca-Cola, grocery chains and pharmaceuticals. The fund is underweight financials.
High-yield corporate spreads last November were more than 2,000 basis points above Treasuries, which was about double the previous wide spread from 2002. Spreads have since narrowed to roughly 1,600 basis points. The historical average is roughly 550.
"The markets are anticipating that the corporate default rate will rise," says Sandy Rufenacht, who runs the Aquila Three Peaks High Income fund. "The trick is whether the high-yield market has priced in the default rate we'll actually experience."
Rufenacht's fund takes what he calls a conservative approach to high-yield investing by avoiding cyclicals such as steel, paper, chemicals, autos, airlines, retailers, restaurants and homebuilders that traditionally have difficulty supporting their debt levels during recessions. Instead, he invests in industries with traditionally good cash flows such as cable, supermarkets, health care and energy that provide greater ability to pay down debt.
The fund also seeks to tame interest-rate risk by focusing on shorter-duration bonds. "Because of volatility we're seeing great opportunities in yields in shorter-dated ones with solid covenants and good cash flow capacity," Rufenacht says.
The high-yield club could soon welcome new members to the fold, given rumors that the likes of Starbucks and Best Buy-along with others-might get credit downgrades. "You don't want to buy into these brand names too early," Rufenacht says. He cites Enron, which after it lost its investment-grade status fell through the high-yield sector and landed in the distressed area in about 30 days. "On the other hand, if you buy them right and the company is transparent, you can make a lot of money. Qwest is an example-it fell on hard times, but it's transparent and it's paying off debt."
Rufennacht says he's not enamored with General Motors because it hasn't been particularly open when he's tried to do due diligence on the company. "This is the type of fallen angel to be careful of," he says.
Some observers believe current yield spreads could be a precursor to an eventual upturn. "I think the steep yield curve we've created is a path forward," says Miller from T. Rowe Price. "Financial institutions make money from low short-term borrowing costs and can invest in longer-duration assets that carry higher returns. They're not doing it today because we're still in deleveraging mode, but I think we're laying the groundwork for a healthier market going forward."