Why You Should Invest in Corporate Debt
Income-hungry investors, rejoice: Higher yields are here. Experts are pointing to the corporate bond market as an increasingly attractive source of generous payouts for fixed-income investors. Positives include signs that the worst of the downturn may be behind us and default rates among corporate bonds are falling. Earnings have been decent and companies are issuing debt at record levels. This is all good news for investors who have been frustrated lately by low yields in investments like U.S. treasuries and money market funds.
The default rate among high-yield bonds -- or those rated lower than investment-grade -- has declined dramatically. At the end of 2009, the high-yield default rate stood at a whopping 13 percent, according to Moody's. That number has fallen to 5 percent, and Moody's expects it to decline to under 2 percent by mid-2011. "That's a pretty dramatic decline," says Sabur Moini, manager of Payden High Income (symbol PYHRX). That means issuers are less likely to default on their debt, and that's good news for investors who are interested in allocating a slice of their portfolio to corporate bonds.
Over the past 20 years, the default rate among high-yield bonds has hovered around 4 percent, according to Moini. "The high-yield market has really purified itself over the last year-and-a-half," he says. Corporations are offering debt at record levels because the conditions (like low lending rates) are attractive enough for them to do so. Globally, Moini expects that there will be more than $200 billion of high-yield -- often referred to as "junk" -- bond issuances by year's end. The total issuance this year has already topped the record $185 billion that was set in 2009.
To put this in context, here are yields for different corners of the bond market. Currently, 10-year treasury bonds are yielding 2.6 percent. Yields have historically been much higher: In mid-2007 when economic growth was much more robust and demand for treasuries was much lower, 10-year treasuries were yielding as much as 5 percent. Because many traditional bond funds that provide exposure to the investment-grade universe are heavy on treasuries, they currently offer relatively low yields. For example, Vanguard Total Bond Market ETF (BND), which covers the spectrum of investment-grade bonds that make up the Barclays Capital U.S. Aggregate Bond Index, currently yields 3.5 percent, according to Morningstar. About 70 percent of the fund's holdings are in treasuries, government agency, and government mortgage-backed securities.
Such funds don't offer enough exposure to corporate debt, experts say. More attractive yields can currently be found in corporate bond funds. "At what point and time, when we do get that economic news to turn better, might we see the threat of higher interest rates, and what's that going to do to treasuries?" says Tom Lydon, editor of ETFTrends.com. "Today we're seeing more money going to corporate bonds where you can get yields that are greater than long-term treasuries that don't have the interest-rate risk if we start to see a spike in rates." When rates finally rise, investments like treasuries will be negatively affected. (That's because when interest rates go up, the price of bonds goes down.) Experts say they don't see a hike in interest rates in the near term, but rates can only go higher.
Instead of sticking with a low-yielding fund that's heavy on an asset class like treasuries, Lydon recommends that investors consider an ETF like the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), which currently yields 4.9 percent. The fund covers the medium-term investment-grade corporate bond universe. For those who have a more defined investing time horizon, Lydon points to some relatively new ETF offerings, the Claymore BulletShares Corporate Bond ETFs. These seven funds hold bonds with maturity dates of 2011 through 2017. (To clarify, the bonds for Claymore BulletShares Corporate Bond 2011 all expire in 2011.) These ETFs allow investors to purchase a diversified mix of bonds that have similar maturity dates instead of selecting individual bonds, which can more time-consuming and expensive. Lydon says the Claymore ETFs can be used as a part of a laddered approach in which investors buy a range of bonds with different maturity dates to guard against interest rate and credit risks. Or they may be a good idea for investors with specific investing goal such as a child's college education, Lydon says.
On this riskier side of fixed income, junk bond funds are now yielding upward of 7 and 8 percent. (Generally, junk bond funds offer higher yields but often come with more risks than investment-grade corporate bond funds.) Payden High Income, for example, currently yields 7.4 percent. An added benefit, Moini says, is the potential for price appreciation (if the underlying bonds prices were to go up in value over time). "Over the next 12 months, you could see high single-digit or even double-digit returns," he says, referring to potential gains among funds that hold junk bonds. Lydon recommends SPDR Barclays Capital High Yield Bond ETF (JNK), which currently yields 10.7 percent. "Equity investors would be happy with that," he says.
The potential for higher yields comes with a fair share of risks. Moini points to two potential scenarios that could be problematic for the sector: A double-dip recession in the United States or more problems in Europe related to sovereign debt in countries like Greece and Ireland. Moini says the team at his investment firm believes the chance for a double-dip recession still exists, but that the probability is very low. He also says he's confident that the situation in Europe is improving.
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