Finding Treasure in a Spooky Bond Market
In the next five years someone will make a fortune in the bond market. That's because bonds of almost every stripe are extraordinarily cheap, with yields in the double digits for such corporate issuers as DirecTV (DTV) and power producer Mirant Americas Generation. But fortunes could just as easily be lost over the next few years. Bonds are so cheap, after all, because of fears the economic mess will generate record downgrades and defaults that leave investors nursing huge losses.
In the worst credit crisis since the Great Depression, investors have fled to the safety of U.S. Treasuries—although they hardly seem a bargain with yields on five-year notes hovering around 1.4% and Washington borrowing hundreds of billions more to shore up the economy. Where are the opportunities? Almost everywhere, if you know how to hunt. Here is our look at the bonds that hold the most promise.
Once upon a time, bonds issued by blue-chip corporations yielded roughly a modest one percentage point more than Treasuries. But panic in the credit markets has created unusual bargains, with the yield spread between corporates and Treasuries topping five points. "I can put together a fixed-income portfolio that yields 8% or 9% without much in the way of [credit] risk," boasts Tad Rivelle, co-manager of the Metropolitan West Total Return Fund (MWTRX), which has beaten 88% of peer funds over the past decade. Right now, roughly three-quarters of Rivelle's fund is invested in AAA-rated bonds issued by companies such as General Electric (GE) and in mortgage-backed bonds from government agencies Fannie Mae (FNM) and Freddie Mac (FRE). The two agencies have long carried an implicit federal guarantee, yet they now yield in excess of 7%. Rivelle also has been dabbling in the "jumbo prime" area—pools of large mortgages made to wealthy borrowers with the highest credit ratings. These currently yield as much as 15%.
If you want less mortgage-bond exposure, consider instead a low-cost, high-quality corporate bond play such as the Vanguard Intermediate-Term Investment Grade Fund, which currently yields 7.3%.
Prior to the credit crisis, Derek Young was leery of junk bonds—lower-grade corporate instruments—because the yields weren't enough to offset the greater risk. But now the co-manager of the Fidelity Strategic Income Fund (FSICX) is adding to his position. "High-yield bonds were yielding only two percentage points more than Treasury bonds in 2007," he says. "Now they're yielding 15 percentage points more. So we've been looking for opportunities to buy back into the sector." Today 28% of the fund is in high-yields, including mining company Freeport-McMoran Copper & Gold (FCX) and natural gas producer Chesapeake Energy (CHK).
For investors willing to hold bonds until they fully mature, the average yields in junk now top 20%, but the risks have never been higher: Standard & Poor's (MHP) estimates that defaults could run as high as 23% by 2010. Investors seeking a pure—but diversified—play on the sector should consider the Harbor High-Yield Bond Fund (HYFIX), which has outperformed 97% of its peers over the past five years. Although his fund has taken a hit in the slide, co-manager Mark Shenkman has minimized the pain by avoiding such volatile sectors as financial services in favor of more recession-resistant sectors such as cable TV and utilities. "People may not pay their car loans, but they pay their utility bills," he says. Some of his favorites include Mirant, Cablevision Systems (CVC), and private prisons operator Corrections Corp. of America (CXW).
Those afraid of junk's risks should consider bank loans, which now sport an average yield-to-maturity of 18%. Although their credit quality is equivalent to junk, bank loans are higher in the capital structure of companies. That means holders are generally first in line for repayment in a bankruptcy. Consider that between 1995 and 2007 the recovery rate on defaulted junk bonds was 43.4%, but the holders of bank loans in default recouped 74 cents on the dollar, notes Oppenheimer Strategic Income Fund (OPSIX) manager Art Steinmetz. "There's been so much more borrowing done using bank loans, and that will put junk bonds—which are subordinate—at a big disadvantage when they default," he says.
Currently the average bank loan trades for 65 cents per dollar of debt, meaning loans are priced below what investors have historically recovered from them during a bankruptcy. "Loans are now much cheaper than any other time in their history," says Jack Yang, managing partner of Highland Capital Management, an investment firm that specializes in bank loans. "We think 15% annualized total returns over the next three years are possible." Given Highland's experience and lower fees, its Highland Floating Rate Fund (XLFZX) merits consideration by investors, as does the low-cost, low-risk Fidelity Floating Rate High Income Fund (FFRHX).
These are tense times in muni land, with many states facing huge deficits. "Michigan is a state we're concerned about," says Warren Pierson, a fund manager at Robert W. Baird, a Milwaukee fund company. "The dynamics in Detroit are not good." Fund managers generally don't expect widespread defaults—the historic rate is less than 1%, since governments can tax their way out of trouble—but these are extraordinary times.
For investors seeking the most protection, the safest muni fund may be the Baird Intermediate Municipal Bond Fund (BMBSX), which Pierson co-manages. It is 79% invested in "pre-refunded" muni bonds, which local governments float to pay off existing, higher-rate debt and then collateralize with U.S. Treasuries. These pre-refunded bonds have become quite the bargain, with yields rising from about 80% of a comparable Treasury to as much as double the yield of U.S. bonds. Pierson's fund currently yields 3.3% tax-free. That's equivalent to a 5.1% return for investors in the top bracket—or 2.9 percentage points more than the current yield on 10-year Treasuries.
For those willing to take on a little more risk, the Fidelity Municipal Income Fund (FHIGX), which yields 5% tax-free, is another excellent choice. It has beaten more than 98% of its peers over the past decade, thanks to a 25-member research team that is among the industry's deepest. Fund manager Christine Thompson considers that deep bench more valuable than ever: "With the demise of bond insurers guaranteeing municipal bonds, the market has become less homogenous, and requires more research to pick the right bonds."
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