Corporate Bonds Looking Better

June 25, 2001 -- Don't look now, but investment-grade corporate bonds — considered boring and banal — have become belles of the ball.

After lagging lower quality "junk bonds" for most of theyear, investment-grade bonds have surged ahead. Lower interestrates are causing investors to reach for yield, while pricedeclines in riskier stocks and bonds are leading some investorsto the relative safety of better quality bonds.

"Fixed income investors are coming back to the corporatesector after a year of fear and loathing," said Stephen Kane,whose Metropolitan West Total Return fund has beaten 95 percentof intermediate-term bond funds in 2001, according to fundinformation service Morningstar Inc.

Through June 19, investment-grade corporate bonds, rated"Baa3" or higher by Moody's Investors Service and "BBB-minus"or higher by Standard & Poor's, have returned 6.07 percent,including interest, according to Merrill Lynch & Co. That worksout to about 13.5 percent a year.

Better Than Junk, Beats the Dow

In contrast, junk bonds were up 3.79 percent, whilesuper-safe Treasuries were up 2.64 percent, according toMerrill Lynch. Meanwhile the best performing stock index,the Dow Jones industrial average, was down 1.8 percent.

Investors are noticing. This year they have pumped a net$14.4 billion into investment-grade corporate bond mutualfunds, according to AMG Data Services of Arcata, Calif.

Investment-grade corporate bonds, a kind of IOU fromcompanies raising cash, now typically yield 5.5 to 8 percent,compared to 3.5 to 5.5 percent on most Treasuries.

The Federal Reserve's five half-point cuts in interest rates this year, designed to keep the economyout of recession, have left investors more comfortable takingon credit risk, after they flocked to Treasuries last fall.

"What happened in 2001 has been a move back to normality,"said Gregory Hahn, chief investment officer at Conseco CapitalManagement Inc. of Carmel, Ind., whose Conseco Fixed Income fund hasalso beaten 95 percent of its peers in 2001, Morningstar said.

The Angels Have Fallen

Most economists, though, believe the Fed has no more thananother half-point of rate cutting to go. If that's true, andthe economy perks up, interest rates could rise, said JasonPeeples, a certified financial planner and principal at GPAdvisory & Trust Group in Memphis, Tenn.

Because bond prices move in the opposite direction ofrates, rising rates can hurt the value of existing bonds.

To guard against this, Peeples said, bond investors should"ladder" their portfolios with bonds of different maturities,and "pay particular attention to credit risk, which is rearingits ugly head this year more than in the past." He favors bondsof Kroger Co., the largest U.S. supermarket chain, whose bondsmaturing in 2007 recently yielded about 6.3 percent.

Indeed, credit risk is as big a concern as ever.

Already this year, companies have defaulted on $50 billionof bonds, breaking last year's record, according to Moody's.Bankruptcies and big losses at telecommunications companies arenow souring investors on many junk bonds, which until last weekhad been outperforming higher quality corporate bonds.

Meanwhile, since December a couple of dozen companies suchas J.C. Penney, Lucent Technologies Inc. and Xerox Corp. have turned into "fallen angels," seeing some of their onceinvestment-grade ratings fall to junk.

What's the Fed Going to Do?

There remain other risks for high quality corporate bonds,particularly that a stronger economy could trigger higherinflation, which also hurts bonds' value.

Still, some experts believe the bonds can hold their own.

"Investment-grade corporate bonds should benefit from theconsiderable uncertainty surrounding profitability and thelimited downside potential for price inflation," said JohnLonski, chief economist at Moody's, in a report. The former, hesaid, can hurt junk bonds, and the latter can hurt Treasuries.

Over time, buy-and-hold investment-grade corporate bondinvestors with well-diversified portfolios could expect to earntheir coupon payments, less a small amount for defaults, lesstrading costs and management fees.

In the short-term, analysts said that with the Fed probablynearly done, now may not be the time to expect rousing returnsfrom investment-grade corporate bonds.

"I think they'll outperform, but I don't expect them toperform as well as they have," said Los Angeles-based Kane."The easy money has been made in the corporate bond area."