The recent recession is somewhat unique in that the credit markets have been dragged through the mud with the equity markets. Bondholders, generally considered to be in a safer position than stockholders, aren’t feeling so at ease. Over the past year bonds across the risk spectrum have declined in price amidst speculation that default rates could skyrocket in 2009 and 2010 to levels unseen since the Depression. As a result, investors with a few years on their time horizon may have a real opportunity right now if they pick and choose their investments carefully. Bond prices are down overall and yields are relatively high. The potential payoff could be even greater if the default rates remain contained and the credit spreads start to narrow.
The percentage of expected corporate bond defaults as implied by current credit spreads is currently over 20%.* Meanwhile, several experts have come out in March revising their expected corporate bond default rates below 15%.** Part of that can be explained by improvements in cash flow volatility and consumer sentiment, both of which are factors in computing credit spreads. Even if an investor remains skeptical of unusually high yielding bonds, there may be other bond investments worth looking at further down the risk spectrum.
Depending on the economy, some of the money going into corporate bonds during the second half of 2009 may come from Treasury securities, the current hiding place during this recession. These securities have seen such a strong influx of cash over the past six months that yields are at historic lows. Short-term treasuries are paying near 0, indicating a consumer confidence level so low that investors would rather take nothing if it means guaranteed safety. If the banks continue to stabilize and the economy shows signs of recovery during the second of half of 2009, I think investors will get bored of these pathetically low returns real quickly. When they do, money may come flowing out of treasury securities and into various bond issues and probably equities as well. That makes now (depending on your risk tolerance and investment objectives of course) an interesting time to consider these riskier assets, particularly high-grade corporate bonds.
If you’re a person with a reasonable time frame, say 3-5 years, I think the best approach may be to purchase a basket of investment grade corporate bonds. Investors can attempt to hedge the default risk by having exposure to bonds of varying duration and credit quality. At the heart of my reasoning is a recent increase in optimism coming out of Washington and from the Feds. Bernanke made it clear on 60 minutes this past Sunday that he stands behind the big banks and has the stated goal of not letting them fail. Similar words have been echoed by Obama, Larry Summers and even Bill Gross, the bond king himself.
On a related note, I think there may be an opportunity in the municipal bond space for investors with a few years on their time horizon looking for tax-advantaged investments. On a recent conference call with Dan Loughran, a municipal bond expert, I learned that money has actually been flowing into this asset class over the past four weeks and an increasing number of successful municipal issues have resulted in a confidence boost in the secondary markets. Fund flows have shown most of the new money heading into high quality municipal issues rather than lower rated, higher-yielding issues. The flight to quality mentality still remains for many investors but some are looking for ways to beat inflation.
Questions or comments on bond investing? E-mail me.
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*Morningstar Bond Market Report: Bill Mast: March, 2009
**CNN Money: January 29th, 2009. “Corporate Bonds Heat Up.”