The investment-grade corporate bond market, all but moribund a short time ago, is astir again, struggling back into action after a rough 2008, with considerable public assistance from the U.S. Treasury Department. And this sector could well represent a buying opportunity for financial advisors seeking higher yields as well as shelter for clients.
Bonds other than Treasurys have been hammered amid an investor crisis of confidence, and many leveraged companies unable to refinance their near-term debt maturities are entering into bankruptcy. (Indeed, the survival of the U.S. auto industry is a big question mark.) A volatile stock market and increasing unemployment are adding further fuel to the fire, because hedge funds and balanced mutual funds faced with increasing redemptions have been forced to meet them by selling bonds to raise money.
These forces have increased the supply of high-quality corporate bonds, driving down bond prices and driving up yields (which move inversely). The bonds of General Electric, Occidental Petroleum and Kraft recently traded at yields of 7% to 8%. The high-quality corporate bonds of companies such as Goldman Sachs and Bank of America yielded 6% to 8% as of mid-December 2008. Other corporate bonds such as Prudential and Hartford Financial with single-A ratings yielded more than 10%. These yields were previously unheard of for high-quality corporate bonds and were instead found in more speculative ones.
If and when this financial crisis eases, bond prices will rise, producing big gains for investors. On the other hand, bond experts warn that if conditions worsen, bond prices could drop further and more companies could be pushed into bankruptcy. And that would mean losses.
Morningstar finds the sector attractive in a recent report but urges caution. So far, it notes that credit downgrades have mostly hit the financial sector, but it expects these downgrades to eventually spread to the broader corporate bond market. Morningstar also mentions the specter of inflation in the future, noting the "incredible rate" at which the U.S. government is printing money to combat the recession.
Spreads Wider Than Ever
Meanwhile, a new breed of bonds for financial institutions that are backed by heavy guarantees from the Federal Deposit Insurance Corp. has roused the credit markets. In effect, individuals and institutions can purchase bonds with the low risk of U.S. Treasurys, but with the yields of a corporate bond. Some funds have reported participating in the initial offering of debt issued by banks such as Goldman Sachs and Bank of America.
Only a few mutual funds invest heavily in corporate bonds, and of those that do, some were hit hard in 2008. Nonetheless, portfolio bond managers are bullish on the outlook for investment-grade debt, saying market prices and spreads are among the best they've ever seen compared with Treasurys, which have experienced yields recently as low as 0%. More knowing advisors are inching into the market.
"I've never seen corporate bonds trade at these spreads over Treasurys in my lifetime," says Kathleen Gaffney, co-portfolio manager with bond guru Daniel J. Fuss of the $11 billion Loomis Sayles Bond Fund (LSBDX), which was down 21.82% last year, and is yielding an eye-popping 13% to maturity. "These are truly unprecedented levels and will not be sustainable," she says. "They should narrow over time, which means very promising returns from this sector."
The average quality of corporate bonds in the fund is a "high BBB," says Gaffney. Among the fund's holdings are Comcast, Verizon and AT&T. On the financial side it holds Morgan Stanley and Merrill Lynch.
Gaffney recommends sticking with longer-maturity corporates. "We don't think the yields on the short and intermediate term are as attractive," she says, "but in the long end of the corporate market, you're compensated by the additional yield on the discounts to par. There's more value in longer-dated maturities, 10 years and out." Fuss, the vice chairman of Loomis, Sayles & Co., is the fund's largest shareholder.