Time to Start Nibbling on Corporate Bonds?

I think Mike Larson did a great job outlining the dangers of longer-term U.S. Treasury bonds in his past two Money & Markets columns. And like Mike, I continue to believe there is more pain ahead for that category of bonds.

Sure, we will probably see a time in the future when yields are juicy enough to make these bonds a good call. In fact, as a reader recently said on my blog,

“[When long-term Treasuries] go up into the mid- to high-single figures? Start buying. And if they go nuts like they did in the Carter years? Sell everything else you have and buy them!”

You’ll get no argument from me there. Along with holding solid dividend stocks for the long term, I think buying Treasuries during periods of high interest rates is one of the smartest moves an investor can make.

But we’re not there yet. And that’s leaving a lot of yield-hungry bond investors wondering what to do right now.

In a previous column, I told you how laddering can help you build a safer portfolio. And I’ve also been singing the praises of inflation-protected bonds such as TIPs.

But today, I want to mention that I am also starting to see some interesting buys in the corporate bond markets …

Why Some Investment-Grade Bonds Are Looking Attractive

So-called “investment-grade” bonds are those that carry ratings of BBB or higher from S&P and Baa or higher from Moody’s.

Now, I’ve said it before, but it bears repeating again — credit ratings are not a guarantee that something isn’t going to explode on you. Just ask anyone who bought highly-rated mortgage-backed securities and collateralized debt obligations a year or two ago!

And even if you accept that investment grade bonds are more creditworthy than most, there’s still one more major risk … the fact that a prolonged recession could punish all companies, even the very strongest.

That’s a valid worry, especially with some forecasts calling for more defaults in 2009 than we saw during the height of the Great Depression.

At the same time, when I survey the landscape, I am starting to see some decent risk-reward scenarios.

For example, I am an unabashed fan of Vanguard’s low-cost funds, and when I look at the firm’s Intermediate-Term Investment Grade bond fund (VFICX), I am intrigued.

The official description says the fund invests primarily in investment-grade bonds with an average maturity of 6.3 years.

But that really doesn’t tell the whole story:

• At the end of February, 22.6 percent of the fund’s holdings held the highest rating of Aaa …

• Another 50 percent had at least one ‘A’ in their rating …

• And because of a big sell-off, the fund’s current yield is right around 6 percent (with a paltry expense ratio of .21 percent)

I consider a 6 percent yield from extremely high quality bonds a pretty good deal.

No, that’s not a barn-burning return by historical standards. In fact, the average yield from 10-year Aaa-rated bonds was north of 9 percent from the mid-1970s through the beginning of the 1990s.

But if the choice is good income from a reasonably safe portfolio of corporate bonds vs. FAR less from Treasuries, I think I’d go corporate at this point in time.

Note that I would prefer to go with the intermediate-term bonds rather than the longer-dated variety that you will find in funds like Vanguard’s Long-Term Investment Grade fund (VWESX).

Again, that’s because rates should rise from here, and there’s no reason to go farther out on the interest rate curve than you have to.

You could also sort through the individual bond markets and find some pretty tasty offerings, many issued by companies you know well.

But in my opinion, that is a task that should be undertaken only if you’re extremely knowledgeable and have a sizeable amount of money to invest in a diversified list of names. Otherwise, you run the risk of one or two defaults ruining your entire portfolio.

In most cases, a low-cost fund from a reputable investment firm is the better choice.

And If You’re Really Aggressive, You Might Also
Find Some Gems in the Junk Department!

Let me be very clear on this: Junk bonds are extremely risky, especially with today’s credit conditions. I would never advocate putting much of your portfolio in these assets … ever.

In fact, they should be looked at more like very aggressive stocks rather than conservative bonds.

Still, it’s interesting to note that many junk bond funds are providing very big yields right now, too.

Again, sticking with Vanguard, you’ll see that the firm’s High-Yield Corporate bond fund (VWEHX) is yielding about 11 percent. And you’ll get that with a very low expense ratio of 0.25 percent.

If you take a look at a chart of this fund, you’ll see just how quickly investors ran from this category of fixed-income investments back in late 2008. The reasons are obvious — a worsening economy, imploding stock prices, frozen credit markets, etc.

But I’m left wondering if all the current — and potential future — pain is already baked into the cake now. For someone looking for big yields, junk may very well turn out to be hidden treasure!

Again, the risk is high … but at a time when long-term Treasuries are handing out very little and looking even riskier, putting a little faith in corporate bonds might be the better choice for the bond portion of your portfolio.

Best wishes,

Nilus

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