If last year saw investors flee to safety in the bond market and hang on to the buoy of Treasurys, this year has rewarded those willing to go out and ride the waves. U.S. corporate bonds in the Barclays Capital index were returning more than 14% by the end of August, while the Merrill Lynch high-yield bond index had earned more than 40%. The S&P 500 index had earned about 14% by that point, comparable to the Barclays Index-but with a lot more risk.
Investment-grade corporate and high yield fixed-income bonds have at some points this year offered 7%, 8%, 9% and even 10% yields to maturity-so much extra juice that you could almost swim in it. And those willing to go farther down the risk band saw even better performance. Even the return differences between 'BB' rated bonds and triple-Cs were compelling.
That had many people plowing money into high yield bonds this year. Net inflows into junk bonds were $15 billion between January and August, according to Financial Research Corp. in Boston, whereas last year, when the high yield lambs were being slaughtered, speculative-grade investors ran for the exits and the net inflow was only $189 million.
According to Miriam Sjoblom, a bond fund analyst at Morningstar, the outperforming intermediate-term bond funds this year have been those focusing on corporate bonds in the mid-quality ratings band of 'A' and 'BBB.' She says some of the big winners are the Loomis Sayles Investment Grade Bond fund (LIGRX, up almost 19% by the end of July), which is mostly corporates, and the more variegated Fidelity Total Bond fund (FTBFX), which popped up almost 14%.
Meanwhile, junk bonds in the 'CCC' category have gone on a huge tear. Among the stronger players, Sjoblom says, were the Fidelity Advisor High Income Advantage FAHCX (up almost 49% by the end of August) and the Fidelity Capital & Income (up a little more than 48%). Funds that focus on distressed or defaulted companies have also done well, she says, such as the Eaton Vance Income Fund (EVIBX), which was up 39%.
Funds weighed down with Treasury bonds, meanwhile, have brought up the rear, and that means passive bond index funds suffered as they lay choked with too many poorly performing T-bills. One such slacker was the Vanguard Total Bond Market Index (VBTIX), which managed to just show a baby bump of 4.58%.
The fat yields on bonds, of course, have benefited from the drop in their prices, which spiraled downward last year as investors feared a new Great Depression on the horizon. Or worse.
"Looking back on the fourth quarter of 2008, the corporate bond market seemed to be pricing in a total Armageddon type scenario," says David Zuckerman, the principal and chief investment officer of Zuckerman Capital Management LLC in Los Angeles who started increasing his exposure to the corporate bond space last year. "At one point, prices were reflecting an expectation of more defaults than we saw during the Great Depression, and we just didn't think that that type of scenario was likely to materialize."
Jason Brady, the portfolio manager of the Thornburg Limited Term Income and the Thornburg Limited Term U.S. Government Funds, agrees. "At the beginning of the year, you were pricing in half of the high yield market to go away in a couple of years. It was basically [anticipation of] a 25% default rate."
The yields were so good some began thinking bonds might even replace stocks in a year of meager returns, especially at a time when equities themselves had wheezed to the finish line and the S&P 500 had actually lost money over the last ten years. Bonds were the new black. They seemed to be offering so much more, and for so much less risk.
Back To Earth
But the party seems to have ended shortly after it got started. Since earlier this year, bonds prices have gone back up. Thus, yields on some lower-rated bonds have fallen from a high of more than 22% to somewhere around 11% by the end of August. Investors say that means a lot of the biggest opportunities are gone. Many of the spreads in the index were hugging the bottom of their 52-week ranges at the end of summer.
"It's quite a significant drop [in spreads over Treasurys] compared to where it was last year," says Sjoblom. "Yes, 11% is a pretty attractive yield, but defaults have risen substantially this year."
According to Moody's Investors Service, the U.S. speculative-grade default rate rose to 11.5% in July 2009, up from 2.7%. The ratings agency expects defaults to peak at 12.7% in the last quarter before easing.
The more important thing, say bond watchers, is that even if bond yields have been tamed and defaults are rising, suggesting that the deals just aren't as good anymore, the market turmoil of 2008 has, in any case, forced all investors to take the risk side of their investments more seriously. Given the long-term questions about the economy and consumer spending, some investors think that, rebound and all, equities might not have the spunk they used to, and bonds might demand a more important position in an investor's core allocation, the life preserver of choice for people who are wiser, more mature and more risk-conscious than they were in the years leading up to the 2007 credit crisis.
Says Brady: "A guy I work with who runs the muni bonds says I don't want equity-like returns. Equity-like returns stink."
Ted Schwartz, CFP, the president of Capstone Investment Financial Group in Colorado Springs, says bond prices may no longer be stunningly beautiful, but they still make for a pretty picture when you put the stock market risk into the equation and the slow-growth the economy might be facing. "When you start looking at risk and reward going forward," he says, "there's still a comfort in that bonds are reasonably valued. They're not overvalued. And [they have] kind of a lower risk profile and we think a lower bar for success."
The bar is lower because all a bond investor wants is for the issuing company to simply survive and pay its debt rather than hit boffo return numbers. Sure, the very solvency of many bond issuers might have seemed iffy last year (when yields made it look like America was going back to an agrarian tent society). But this year financing is loosening up and banks are lending again, allowing many companies that were in jeopardy of default to dodge the bullet. In this environment, say bond enthusiasts, betting on a four-year fixed-income investment that will likely grow to a ripe maturity seems smarter than wagering on a huge profits flowing from the equity side.
Carol Somoano, a CFP licensee with Asset Planning Inc. in Cypress, Calif., with $70 million in assets under management, says her firm has been steadily increasing its holdings in high quality individual corporate bonds since the end of March. For instance, the firm bought Goldman Sachs bonds in May that were yielding 5.4% and maturing in 2012. She bought the notes at $97. By the end of August, that price had jumped to $106. So basically she made 9% on it-and she has the yield on that to boot. She isn't planning to sell the bonds, but if she were, the price differential alone would have given her $1,762 by the end of the summer.
However, she says, as time goes on, it gets harder to find deals as good as the ones she was finding in May-"because a lot of people are doing what I'm doing."
"This is not an equity replacement," she says. "But it is a way right now to buy regular fixed income." After all, annual five-year CD yields are about 2.65%, money market annual yields about 1.17%. "So it was basically a way of getting back some of the losses that occurred in the past few months and knowing that we're going to get this 5% off Goldman."
While she was interested more in financials earlier in the year because of the government's willingness to shore up those companies, she says she's now more interested in industrials, especially those she thinks are rated unfairly by S&P and Moody's.
"Their prices are still lower; they still haven't come up yet," she says. "But you're looking at good companies that we think are going to survive." One she just bought is a bond offering by department store Macy's. "It's considered industrial on the bond market, a 'BB' [rating by Standard & Poor's]. The coupon is 7.45% and it's trading at less than par. So my yield to maturity is 8.2%. That is more of a risky one. But just looking at Macy's-yes their earnings are down, retail sales are down. But I still think they're going to be in business in 2011 when the bond matures. So 8% is a pretty good return."
The big selling point is she knows she's not going to lose money but at least get back par. This is an important for retirees who need to depend on the income.
Joel Framson, president of Silver Oak Wealth Advisors LLC in Los Angeles, says that his firm starting using bonds as an equity replacement last October, "primarily because we didn't like what we saw in pretty much any of the traditional asset allocation approaches we've always used-along with, I'm sure, all of the other advisors across the country." The firm contacted all of its clients and moved between 80% and 100% of their money out of those approaches, and moved about 50% to 60% into individual bonds. The firm's principals started with U.S. agencies such as the Federal Home Loan Bank, but then segued into corporates when the firm saw what the yield spreads were.
"The coupons really didn't matter that much," he says. "The coupons might have been in the 5%-6% range. But the yield to maturity was in the 7%, 8% and 9% ranges. We're talking about bonds that matured generally between 2010 and 2014. So it was between the short term and the short end of the intermediate term."
Though the idea was to hold these names until maturity, the increase in the bond prices allowed the firm to trade bonds like stocks, Framson says. "It took a little intestinal fortitude at that time because you're buying names like JPMorgan, American Express. You're buying financials. All we have to do is explain to our clients that any fluctuations were going to be temporary as long as the companies were solid."
Now that the spreads on investment-grade bonds have been reeled in a bit, investors may feel that old craving for yield and may look to the junk bond space to get it-just the kind of nic fit that led to the dodgier credit problems of the last few years. And judging the landscape in high yield is a bit more dicey. In fact, Brady doesn't see that many good deals in high yield at all.
There are some good deals, he says, but "the compensation you're getting for the risk that you're taking is not that great." Indeed, even though the market is rewarding riskier investments this year in a way it didn't last year, high-yield fundamentals are continuing to deteriorate says Morningstar's Sjoblom. "Defaults are rising and recoveries are expected to be lower than they've been historically," she says. "So there's still a lot of risk to watch out for in that sector."
Brady, whose Thornburg Limited-Term Income fund was up 13.38% for the year by August, says that the equity replacement story on bonds is largely over. Nonetheless, the recession has forced people to look more closely at their asset allocation and their risk tolerance.
"The equity like return story where you're getting 8%-10%, that's not really there for very high quality bonds anymore," Brady says. "What I think people are understanding though is that one, we're still looking for income basically any way they can get it, and two, the asset allocation that they may have had over the last couple or three or four years hasn't really worked out for them. I'd say a lot of investors are very overweight in stocks relative to a recommended portfolio."
The real question, he says, is this: "Has your portfolio performed the way you want it to before?"
"If it hasn't, considering a core allocation to fixed income is probably a reasonable thing to do."