Pause Before Jumping on the Corporate-Bond Wagon

Thinking about jumping headfirst into corporate bonds? Well, you may want to weigh the pros and cons before you leave the diving board.

If you were reading the Columnist Conversation Monday, you'd know that I took the proceeds from an earlier sale of my small mortgage-backed position and added to my investment-grade corporate-bond holdings. This meant that I traded prepayment risk for credit risk, but I didn't increase my total risk. Sure, I think corporate bonds offer a lot of value. But I'm in no rush to add to my total risk, especially as I'm already overweighted in corporates.

After Sept. 11, investment-grade corporate bond yield spreads immediately gapped out by 30 to 40 basis points, a tremendous movement in a short time, and then narrowed 10 to 20 basis points in the past few weeks. Spreads didn't reach the peaks they saw late last year (meaning that corporates have still outperformed Treasuries this year), but they're within hailing distance of that level and of the spikes of the early 1980s and 1987. Because short-term yields have come down so much, shorter corporates have had positive absolute returns since Sept. 11 despite the spread widening, while long corporates have posted negative returns.

What's Behind It

There are several reasons for this widening of spreads. First is the flight-to-quality response that typically occurs in times of stress. Investors flock to the safety of Treasuries, leaving non-Treasury sectors in the dust. Second, the economic impact of Sept. 11 has worsened the corporate credit outlook. Third, insurance companies needed to liquidate some of their bond (and stock) holdings to pay claims arising from the attacks. Let's take them one by one.

Treasury demand: Higher future federal spending and lower taxes will result in a higher-than-expected Treasury issuance. The jury's still out on whether the flight-to-quality bid will be persistent enough to keep Treasury yields low. If retail investors do start gravitating to bonds, then these flows should keep Treasury yields down and gradually lend support to corporates. This support would be gradual because lower bond yields are likely to produce more corporate issuance; you'd probably earn your coupon and not realize a sudden payday. If retail support isn't sufficient, then short-maturity Treasuries would be very vulnerable, especially in the two- to five-year area. If Treasury yields rise in response to new supply, then investment-grade corporates should greatly outperform them due to a crowding-out effect.

Credit quality: While it's hard to get a handle on the economy now, it's possible to try to examine which outcome markets are discounting. While September's events certainly had a negative impact, we still don't know how long or deep this recession will be. However, given that spreads are historically very high, they're discounting a bad credit cycle.

Investment-grade corporates make sense for investors looking to boost their income. If you're underweighted, consider adding some. However, while I'm overweighted, I'm not close yet to my maximum position. Why not? Why do individuals need to think this through before acting? It's because of the forces of supply and demand.

Buying and selling: Insurance companies have had to sell assets in the past month in order to pay claims. However, given how thin the spread markets have been, my sense is that they haven't finished selling in those sectors.

Year-End Troubles

Hopefully, the bulk of these sales will wrap up in the next few weeks, because bond-market liquidity will soon hit its seasonal low. Financing in the bond market is always difficult at the end of the year. In recognition of this, most dealers have switched to a November fiscal year and are reluctant to build inventories in the weeks before their books close. The good news is that insurance-company selling will hopefully have run its course, and dealers' inventories seem relatively low. However, this could be offset by investors' increased demand to show safe credits on their books. Coupled with a reduction in trading capital from the brokers, this could result in a particularly nasty year-end. So, rather than be ultraaggressive now, I'd wait until around Thanksgiving to take advantage of any further dislocations.

The Standard & Poor's downgrade of Ford (F) and General Motors (GM) Monday also could complicate the year-end. These downgrades shouldn't affect the automakers' ability to obtain financing, though, and they should be able to meet their reduced commercial paper needs.

But it could significantly impact the rest of the commercial paper market. Ford and GM are two of the largest commercial paper issuers, and their short-term ratings are low enough that many money-market funds won't buy their paper now. They'll be forced to rely on institutions that buy paper directly. These institutions have been abandoning direct holdings in favor of money funds, so the market for direct instruments has shrunk.

While GM and Ford should be able to place their paper, lesser firms that rely too heavily on short-term debt issuance may be unable to roll over their paper. From an equity standpoint, investors should examine their holdings' balance sheets and consider purging companies with too much short-term debt.

This caution extends to high-yield holdings as well, although I don't view them as a substitute for investment-grade bonds, but for stocks. In that context, high yield has done well, down 1% to 2% since I recommended buying them in early January, when compared with broad stock market averages. However, these declines are still unpleasant, considering that high yield was up more than 6% this summer, only to give it all back and more in September.

Estimates for the peak of future corporate defaults have risen from around 10% in early September to around 11% now, and expectations for that peak have been pushed out beyond mid-2002. Add that to current yield levels, and high yield can offer value for investors with a decent time horizon. As I already own some high yield, though, I'll wait to see how year-end forces shape up before committing more money. If dislocations still persist then, I'd plan to add to high yield with money previously earmarked for stocks.

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