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Tantalizing Opportunities in High-Grade Bonds
By Robert Huebscher
October 28, 2008

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High-grade corporate bonds are selling at compelling yields on a historical and absolute basis.  Advisors funding income portfolios should look closely at this asset class.  But the potential for rising inflation and credit defaults has been heightened by the unprecedented financial crisis and huge corporate failures that have already occurred. 

 

When the bond market closed on Friday October 24, a Goldman Sachs 6.15% 2018 bond was trading at $83 to yield 8.85%.  That represented a yield spread — the interest above an equivalent-term Treasury — of 524 basis points.  Typically, that spread would be well under 100.

Going further out on the maturity spectrum, investors were rewarded with similar spreads.  The Comcast 6.40% 2038 bond was yielding 8.43%.  The AT&T 6.40% 2038 bond was yielding 8.53%, and the Home Depot 5.875% 2036 bond was yielding 10.00%.   Thirty-year Treasury bonds are trading at slightly over 4.00%, so these are spreads of 400-600 basis points for high-grade liquid issues.

Clearly, the high-grade bond market is pricing in a worst case scenario.

According to Elaine Stokes, co-portfolio manager of the Loomis Sayles Bond Fund, “investment grade credit is trading at historical levels - a long term investor will surely be rewarded for taking the plunge.”

For advisors constructing income portfolios, quality high-paying bonds represent an intriguing opportunity to lock into near double-digit yields.  However, high-grade bonds may still prove to be a volatile asset class, subject to risks from deteriorating economic conditions, widening spreads, along with rising inflation, interest rates, and defaults.

Reading Spreads

According to J.P. Morgan’s High-Grade Strategy and Credit Derivative Research, the average spread on its industry-diversified, high-grade portfolio has soared to 426 bps.  During the summer of 2007, it was less than 50 bps.

Two forces have caused spreads to explode.  Corporate yields are rising due to the combination of frozen credit markets, recession anxiety, and rising default rates.  According to Standard & Poor’s, investment-grade defaults were virtually non-existent over the past several years.  But, as of August, defaults had jumped to 32 basis points, and are expected to rise further.

Spreads

Source:  Standard & Poor’s, September, 2008

But that’s only half the story. 

At the same time, the flight to quality has compressed Treasury yields to some pretty deep lows.  Investors are pouring into supposedly ultra-secure government paper, further widening the spreads.  Three-month notes were recently paying 5 basis points; one-month notes were being purchased above par, offering negative yields.

HG Bonds

Source: JP Morgan, September 24, 2008

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