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Where the Credit Freeze Has Thawed

Amid the new "Ice Age" in credit markets, some bond market pros are still finding attractive opportunities. Here's what they're buying

The global half-percent interest rate cut coordinated by central banks from the U.S. to China on Oct. 8 sparked yet another glimmer of hope for a thaw in the frozen credit markets, but the unprecedented action also underlined just how grave—and widespread—the financial crisis has become.

The coordinated rate cut came one day after the Fed said it was creating a special funding facility to buy three-month unsecured and asset-backed commercial paper directly from eligible issuers—an attempt to relieve some of the strain in recent weeks caused by a pullback by money-market mutual funds and other cash-strapped investors. That move encouraged some fixed-income fund managers but made others, such as Bill Larkin of Cabot Money Management in Salem, Mass., more nervous. Commercial paper leverages the hard assets of more creditworthy companies, and if those companies are having trouble getting short-term loans, the implications for higher-risk companies are even worse, says Larkin.

Some investment strategists believe the global rate cut and other groundbreaking moves by the Fed designed to jump-start liquidity will eventually cause loans to start circulating through the system again. In the near term, however, the unwinding of debt positions will continue "until there's some equilibrium reached between the supply of risk and the demand for risk," which could last for another couple of weeks, Manny Labrinos, credit portfolio manager at Nuveen Asset Management in Chicago, wrote in an e-mail message.

Not Everyone is Hurt

From the news headlines, anyone would think that the credit freeze has incapacitated all publicly traded companies equally, leaving all of them stranded without access to the capital markets. But that's not the case.

Despite the relative absence of liquidity, some bond investors still have some appetite for individual corporate bonds, if the price is right, says Labrinos at Nuveen. "I have to be concerned that a month from now if I decide to sell my bonds, will Wall Street be there to provide a bid for me?" he says. "I'm going to request a premium for any [individual] cash bond right now, because I have to take into account that I may be stuck with it for a while."

There's no price at which James King, president and chief investment officer of National Penn Investors Trust in Reading, Pa., is willing to buy corporate debt right now given the dearth of buyers in the market. "Until that frees up, I'm on the sidelines with the existing [bonds] I had," he says.

Decrease in Bond Deals

The number of corporate bond deals done in the first nine months of this year has dropped dramatically from last year. For investment-grade companies, there were 834 bond offerings for a combined value of $551 billion through Sept. 30, compared with 1,782 deals for a total value of $752 billion for the same period in 2007, according to Diane Vazza, managing director of global fixed-income research at Standard & Poor's.

For speculative-grade companies, the decline was even sharper— 101 deals had come to market for a combined value of $37 billion, vs. 246 deals for a total value of $107 billion in 2007, says Vazza.

The lack of liquidity is reflected in credit spreads, the differential between the yields on corporate bonds and those of comparable maturity risk-free Treasury bonds. Spreads had been widening since the summer of 2007 but have reset at five-year highs 12 times since mid-September, around the time the U.S. Treasury announced its $700 billion financial rescue package, says Vazza.

Risk Priced In

On Oct. 7, credit spreads on the bonds of speculative-grade companies were 10.55% above Treasury notes, signaling the elevated level of risk being priced into this debt. "Companies are choking if they have to come to market, because [of the] margin above Treasury yields," says Vazza.

Spreads for investment-grade bonds were 3.7% higher than comparable Treasury notes on Oct. 7, which Vazza called "rather extraordinary."

The investment-grade bonds of entire sectors have been unfairly punished due to the general lack of liquidity as a result of spillover from the financial industry. In the energy sector, exploration and production companies like Chesapeake Energy (CHK) and integrated oil producers are relatively safe bets despite sharply lower oil prices since they are still generating heaps of free cash flow and have very little debt on their balance sheets, says Labrinos. The recent widening of their credit spreads to dramatic levels, however, has given investors reason to wonder about how safe they are, however.

Driven by Investor Demand

Demand for the bonds of metals and mining companies has also retreated lately as stocks such as Freeport McMoRan Copper & Gold (FCX) have taken a beating. But bondholders of both investment-grade and high-yield issues have less reason to be worried as these companies continue to amass cash, have adequate liquidity and very little debt, he says. Labrimos also recommends the high-yield bonds of regional communications companies like Frontier Communications (FTR) and wireless companies such as Sprint Nextel (S), which haven't loaded up on debt and have more conservative business models than they once did. He views aerospace and defense companies as less risky by virtue of not being having much exposure to the business cycle.

"A few months ago, we thought high-yield bonds were too expensive," he says. "Now we see lots of value out there," but investors need to distinguish between sectors and do their homework.

Most of the corporate debt deals are being driven by investor demand rather than just companies' need for capital, says Jim Keegan, portfolio manager of the Ridge Worth Intermediate Bond Fund (SAMIX). Union Pacific's (UNP) offering of $750 million worth of 10-year bonds was one of just three deals priced last week. It came to market as a was a reverse inquiry, where the term and nominal yield—a 7.875% coupon—were suggested by investors through a dealer and accepted by the company. "It's the old saying 'You borrow when you can, not when you have to,' and that's been clearly on display the last few months," says Keegan. "The railroads are a capital-intensive industry. It's always better when you're borrowing money that there's demand for that type of credit."

Investors Are Spooked

Keegan says his focus has been on high-quality defensive names in the consumer staples, utilities and pipelines industries that have healthy levels of free cash flow and little need to refinance debt in the next 18 months.

While most bond investors are too spooked by the mounting body count in the financial industry to retain much of a stomach for high-yield corporate bonds, Labrinos sees their record-high yields as a sign of good value in general, but advises investors to be selective by sector. Spreads of 14% above comparable Treasury yields are implying defaults that are much higher than anything seen thus far, he says.

Cabot's Larkin likes the bonds of AT&T (T), Verizon Communications (VZ), and CVS Caremark (CVS) as defensive plays. General Mills (GIS), Kimberly-Clark (KMB), and Anheuser-Busch (BUD) are of such high quality that their bonds are prohibitively expensive right now, he says.

Protection Against Credit Risk

More affordable, he says, are some older Anheuser-Busch bonds he bought on the market recently that have a 9% coupon and mature at the end of 2009. One key attraction was a feature that's been missing from corporate issues for the past 10 years: credit-rate-sensitive puts. Those puts allow the holder to put the bond back to the issuer for full redemption if the bonds fall below investment grade, That type of added protection will definitely make a comeback as companies try to be more competitive in order to attract investors, he predicts.

"Everybody thinks the capital markets are broken. I just think the capital markets were too cheap," he says. "[Deals] will get done, but they will just get done at the right conditions. The market has to adapt and the problem is adapting can be difficult."

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