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Are Corporate Bonds a Deal?

The stock market has erased its post-September 11 losses, but bond investors seem to have a decidedly more pessimistic view of the future. The evidence? A big jump in the risk premium on corporate bonds--that is, the difference between corporate-bond yields and the yield on safer U.S. Treasuries. The risk premium for industrial junk bonds rated B+ by Standard & Poor's has risen to six percentage points above Treasuries, vs. about 4.5 percentage points before the attack, as investors worry that the issuers will default.

Even the least risky corporate bonds--the relatively scarce long-term bonds issued by top-rated borrowers such as General Electric Capital (GELK)--have risk premiums that remain way above their historical average.

The spread between long-term bonds rated Aaa by Moody's Investors Service and 30-year Treasuries averaged 1.7 percentage points in September. By comparison, the spread was as low as half a point in the mid-1990s. Last year, the spread got as high as two percentage points, which was the highest in at least 20 years (chart). It briefly narrowed this past spring and summer, but pessimism about the risk of defaults seems to be returning, says Michael Cosgrove, head of Econoclast Inc., a Dallas-based economic consultancy.

If the yield spread is wide when the economy is close to a bottom, buyers of corporate bonds can lock in high interest rates with little fear of default. But the real possibility of a deeper recession means that corporates may not be such a bargain after all. "We still don't have a good handle on how successful the Fed will or won't be in turning this economy around," says Kenneth L. Hackel, Merrill Lynch & Co.'s chief U.S. fixed-income strategist. As a result, he warns, "it's not clear to me at all that wide does equal cheap." Since the launch of the euro in January, 1999, the European Central Bank has struggled--its critics say unsuccessfully--to set appropriate interest rates for a currency bloc that includes fast-growing tigers such as Ireland and Finland as well as laggards such as Germany and Italy. A single, Europe-wide monetary policy was bound to be too loose for the fast-growth countries and too tight for the laggards.

But the central bank's dilemma may be getting easier as the economies of the 12 nations that make up the euro zone are behaving more alike. The difference in growth rates between the fastest-growing member of the euro zone and the slowest has narrowed from 8.1 percentage points in 1999 to about 3.4 percentage points this year. Similarly, inflation and unemployment rates across Europe are moving closer together. And wage levels and living standards in the poorer countries on the euro zone's rim are catching up with those in the richer nations.

To be sure, the economies of some euro zone countries, such as Germany, are less flexible and deregulated than those of others, such as Spain. Moreover, the narrowing of the growth gap has occurred in a less-than-ideal way: through a slowdown by the highfliers, rather than an acceleration by the sluggish countries. Still, whatever the reason, "more and more they are moving in the same cycle," says Kevin Gaynor, an economist at UBS Warburg in London. "This is what economic and monetary union was meant to make happen."

That doesn't necessarily mean that policymakers will make the right monetary decisions, of course. On Oct. 11, the governing council decided to leave rates unchanged at 3.75% even though most business folk favored a reduction. "Wherever they come from, they still seem monetary hawks at heart," says Friedrich Heinemann, an economist with the Center for European Economic Research in Mannheim, Germany. "Convergence won't change that." In uncertain times, volatile emerging markets are generally poison ivy. Indeed, the Morgan Stanley Capital International Emerging Markets Index is down 22% year-to-date in dollars. "The world is a riskier place than it was Sept. 10," says Brian Gendreau, emerging-markets strategist at Salomon Smith Barney in New York. "No one wants to explain why they have Brazil in their portfolios."

Yet surprisingly, the only markets that have gained this year are also emerging ones. Each of the winners has its own story. Oil is behind the 34% rise in Russia's benchmark RTS Index. "Russia has a current-account surplus, a stronger currency, and it's a commodity producer," says Gendreau. South Korea's relatively strong performance--its Composite Index is flat year-to-date in dollars--reflects government efforts to boost local demand as export markets flag, among other factors. Slovakia's SAX index is up 27% in dollar terms this year, helped by expectations that MOL Hungarian Oil & Gas PLC will raise its 36% stake in Slovnaft, which is half the index, to over 50% says B. Scott Sadler, emerging-markets portfolio manager at Wachovia Corp. Asset Management. Other gainers in dollar terms are Costa Rica, up 11%; Jamaica, 13%; and Ecuador, 30%.

But even if an investor is lucky enough to pick the right emerging market, there's a problem. In the smaller markets, the capitalization is so low that "it doesn't take much to buy the whole thing," says Marcel Cassard, chief emerging-markets economist for Europe at Deutsche Bank in London. Conversely, it's hard to sell without moving the price--making it hard to get your money out.

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