While stocks have been rallying lately, the big investing story these days may be corporate bonds, where soaring yields are drawing strong interest.
Many corporate bonds, particularly those in the financial field, are offering double-digit yields, while the Dow Jones Corporate Bond Index is just above 7 percent. The gaudy yields are a strong enticement even though the threat of defaults makes the bonds highly risky.
"Credit markets aren't working properly so investors don't want to take the risk. To attract investors they have to keep pushing up the yield," says Heater Errigo, managing director at Lynx Investment Advisory in Washington, D.C. "At some point the yield spreads have to narrow back in ... but right now it's a great opportunity. You can buy some high-quality corporate bonds that can give you some great yields."
Spreads between corporate bonds and Treasurys have hit about 4 percentage points, a trend stimulated both by a rush to the safety of government issues and a drop in demand for corporates on fear that the companies issuing them may not make good on their debt.
At the same time, the surge in stocks, while pronounced, still leaves the major indexes well off their highs for 2009, and the past two days have seen the market wobble. That has sent investors looking for returns elsewhere.
Investors can buy bonds either directly, using a manager, or through funds, with a surge of activity particularly in exchange-traded issues. An initial direct investment into corporates usually requires at least $5,000 but the amount varies, while ETFs can be purchased as easily as stocks.
"They're always a legitimate investment opportunity. You just have to be selective at what you buy," says Dennis P. Barba Jr., professor at the Weatherhead School of Management of Case Western Reserve University. "Do some research into the company and have a reasonable sense that they're going to be solvent."
But for retail investors the calculus is difficult, and some investment pros are loathe to recommend corporates.
"For income, bonds are great, but you better know the risk factor," says Bill Walsh, president of Hennion & Walsh Asset Management in Parsippany, N.J. "If we had a client right now that has to buy corporates because they want that extra yield and understand the risk, what we would suggest is instead of taking that one corporate, use a professional manager."
Managers have taken a liking to ETFs that track the performance of indexes measuring corporate bonds.
The iShares iBoxx Investment Grade Corporate Bond (NASDAQ: LQD) fund has seen strong money flows over the past week though it is down about 7 percent for 2009.
Another of the more popular ETFs for the group, the iBoxx High Yield Corporate Bond (NYSE Arca: HYG), is off nearly 8 percent this year but has gained about 12 percent in the past two weeks.
Another of the more actively traded ETFs in the group is the SPDR Barclays Capital High Yield Bond (NASDAQ: JNK), which also has gained 12 percent since March 9.
Enthusiasm From Money Managers
Indeed, the demand for corporates is on the brink of bullishness.
The Investment Manager Outlook, a quarterly survey of investment pros conducted by Tacoma, Wash.-based money manager Russell Investments, found 67 percent of managers bullish on corporate bonds and 61 percent bullish on high-yield bonds in general. Both categories were more popular than stocks.
"In this environment of caution and realism, managers are finding opportunity in spreads between high-quality corporate bonds and Treasurys that are at historic levels," Erik Ristuben, Russell's chief investment officer, said in a statement.
"Managers also see attractiveness in high-yield bonds, which may constitute a very good value compared with a possibly even more volatile equities market, especially for those managers who can discriminate and effectively pick the winners."
To be sure, the other end of the double-edged sword in the corporate yield surge is an uncertainty over the future of equities.
Stocks have staged an impressive rally this week, but the Dow industrials are still 13 percent below their January peak after the post-election rally.
Investors are pricing in a five-year default rate of 40 percent for corporates, according to Deutsche Bank, indicating that a sustained run higher in stocks could be difficult amid all the troubles companies will be facing in the days ahead. The number also serves as reminder of how important it is to pick the right bonds.
"A trend upward is not going to happen until the corporate market goes back to normal," Lynx's Errigo says. "We have to have lending go back to a normal level before the equity markets are going to have a sustained rally. It's definitely a reflection of the uncertainty in equity markets out there."
The Russell survey also has found sentiment declining for stocks, even though a 57 percent majority still finds the market underpriced.
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"Managers want to know that the economy is functioning properly again and believe that the credit situation is the key to understanding when the economy and markets are set to recover," Ristuben said.
Until the equity markets stabilize, investors will have to decide just how much risk they're willing to take. Those with a high appetite could find a nice reward in corporate bonds.
"My discussion with the retail investor would be: Do you know the risk and do you want that risk, and if you do is there a way to diversify that risk?" Walsh says. "I don't know if I believe the reward is worth the risk at this point for an individual investor."
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