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 is 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%-8%. The high-quality corporate bonds of companies such as Goldman Sachs and Bank of America yielded 6%-8% as of mid-December 2008. Other corporate bonds like 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 24% through Dec. 19, 2008, and 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.
At separate press briefings in New York recently, Thornburg Investments and MFS Investment Management expressed bullishness on both the current corporate bond and municipal bond markets.
“There is no reason to step into any market and buy low-quality assets today,” said Mike Roberge, CIO of U.S. investments at MFS Investment Management. “You can buy high-quality assets at compelling valuations, so there’s no reason to take excessive risk. We are in a capital protection market, not one where you want to try to capture significant upside.”
Jason Brady, director of fixed income at Thornburg Investments and portfolio manager of the $2.5 billion Thornburg Investment Income Builder Fund (TIBAX), echoed those sentiments. He believes that the worry about more defaults in the corporate bond sector has been overblown. “Currently, investment-grade bonds are priced for a scenario where 50% will be in default over the next 10 years,” Brady said. “Obviously, I don’t foresee that coming about. The largest percentage we’ve seen over a 10-year period since 1980 is 5%.”
The average corporate bond rating in the Thornburg Investment Income Builder Fund is BBB+. Brady and the other managers favor the steady cash flows of businesses in the utility, cable and telecom sectors. The fund’s negative 36.44% year-to-date return through Dec. 19, 2008 (a date at which it yielded 7.5% at that time), reflect recent changes in the fund. “We increased the fixed-income holdings from 15% to 38% within the past year, and most of that was done in the last three months,” he notes.
Although not bullish on either the fundamentals or technical aspects of the current corporate bond market, Andrew O’Brien, portfolio manager of the Lord Abbett Income Fund (LAGVX), says, “What’s being priced in is a much worse scenario than we’re expecting, and unlike with securities that don’t produce income, with corporate bonds you get paid to own and wait for things to get better. So it’s a good time to be involved.” About 70% of the fund’s assets are allocated to corporate bonds.
Furthermore, says O’Brien, “You’re getting paid to take the risk, and it’s a good time to have an active manager working with you, somebody who can sort through and find the babies that are getting thrown out with the bathwater and avoid the credits that people ought to be avoiding.” The fund was down 11.98% year to date through Dec. 19, 2008, and yielding 6.8%.
Perhaps another fund worth looking at is the CNI Charter Corporate Bond Fund (CCBAX), managed by City National Asset Management, the investment management group at City National Bank in Los Angeles that manages or administers nearly $53 billion in assets.
Currently, the CNI bond fund has all its assets invested in high-credit-quality notes, bonds and debentures. Recently, it added some Federal Deposit Insurance Corp.-insured bonds, according to Rodney J. Olea, the director of fixed income at City National Asset Management who co-manages the fund with William C. Miller Jr. The managers are also positioning the fund to add some industrial bond issues over the next few months. Among the fund’s largest current holdings are Wells Fargo, Toyota Motor Credit and GE Corporate Credit.
The N shares of the fund were down only 1.65% year to date through Nov. 30, 2008, while the Lipper Short Intermediate Investment Grade Debt Index was minus 5.13% for the same period, and the Morningstar Intermediate Term Bond Index average was negative 7.84%. Since inception in 2000 through the end of last November, the City National fund’s N shares posted a total annualized return of 4.51%. (Class N shares are typically shares available to the public without charging a sales load. The exact definition and applicable fee differentials between share classes will vary from fund family to fund family.)
An alternative way to access the corporate bond market is through low-cost exchange-traded funds, which offer increased liquidity and transparency. Barclays Global Investors says its iShares iBoxx Investment Grade Corporate Bond Fund (LQD) has experienced tremendous volume boosts, as has its ETF focused on the Barclays Aggregate Bond Fund (AGG). “We’ve seen trading volumes in the LQD quadruple since last June, while assets have grown by more than 40% over that same time period, to $5.5 billion,” says Matt Tucker, head of investment strategy at BGI. According to Morningstar, the iBoxx fund offers good exposure to investment-grade bonds, but it is fairly concentrated in certain industry areas, and it these industries stumble, it can hurt returns.
In a troubled market for equities as well as bonds, some advisors are stepping up to the plate and buying corporate bonds and bond funds for clients. Others are holding back, citing liquidity and credit concerns.
L.J. Altfest & Co. has increased its purchase of individual taxable bonds and bond mutual funds for its clients by investing in funds by PIMCO, Vanguard, Loomis Sayles and Trust Company of the West (TCW), according to Nandini Wamorkar, a CFP and advisor at New York-based Altfest. “Armageddon-type default scenarios are being reflected in prices of high quality corporate bonds. Investment-grade corporate bonds are being priced on average of 525 basis points over LIBOR, which implies a 35% default rate. This clearly supercedes defaults observed in the past,” she says.
On the other hand, Legend Financial Advisors Inc. in Pittsburgh has not been an active buyer of corporate bonds or corporate bond funds. “With the credit crisis, there’s limited liquidity with bonds, so if you were to buy a bond you’d have a hard time selling it if you wanted to,” says Jim Holtzman, a CFP, CPA an advisor at the firm. The few bond mutual funds the firm is buying have only limited exposure to corporate bonds, he says.