Bonds May See Huge Gains in Coming Years

The investment-grade corporate bond market has had the wind at its back, driving bond prices higher and yields down, and though the rally has fizzled in the last two weeks, these bonds could still deliver double-digit gains over the coming year or two.

Fixed-income managers as well as equity investors still see tremendous value in corporates of as much as 10 percentage points over comparable Treasurys, providing equity-like returns.

"We went into the year with strong expectations that we could get outsized, double-digit returns from spread product through investment-grade corporate bonds — and we still believe that," said Keith Wirtz, president and chief investment officer of Fifth Third Asset Management, which manages $22 billion.

Driving the interest in corporates is not only the returns investors foresee, but the fact, as Wirtz said, that equities remain vulnerable.

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Many equity investors like Wirtz joined their bond counterparts, piling into high-grade corporates late last year when the spread over U.S. Treasurys widened to over 6.5 percentage points — an amazing risk premium considering the historical spread of about 1 percent.

Spreads have since narrowed as a rally in corporates cut the cash spread by more than 100 basis points from a peak of 656 basis points over Treasurys in early December, according to Merrill Lynch indexes.

Investment-grade corporate bonds are rated "Baa3" and above by Moody's Investors Service and "BBB—minus" and above by Standard & Poor's.

Lawrence Jones, an associate director of fund analysis at Morningstar in Chicago, said despite corporates' rally late last year into early this year, "There's probably still more room to go in 2009."

"A lot of the managers we speak with make the case that these are still fairly compelling options," Jones said. "Maybe not as compelling as they were in say late November or late December, but still quite attractive when you're looking at other options."

Little Cushion in Treasurys

Wirtz said corporations are looking to preserve cash, which means many U.S. firms might cut or even eliminate dividends which places more pressure on equities.

For their part, bond investors say Treasurys are under pressure too.

The government is expected to borrow about $2 trillion of debt this year to finance its rescue packages for the battered banking sector. Already, outstanding Treasury debt stood at $5.5 trillion at the end of September.

Ken Volpert, head of the Taxable Bond Group at The Vanguard Group, where he oversees about $200 billion in assets, said the enormous funding needs Washington is taking on as it tries to pull the U.S. economy out of recession and remove troubled assets from banks could lead to a decline in Treasurys.

"It's very reasonable to think that corporates might outperform Treasurys by 10 percentage points a year for the next two years," Volpert said.

Jack Ablin, chief investment officer of Harris Private Bank in Chicago, also has been favoring corporate bonds.

"Treasurys are in their own unique dream world, trading at around 3 percent for a 10-year Treasury note — and that is supposed to be a good investment, assuming zero inflation over that time?" Ablin said.

Jones recommended three options for those interested in funds that invest in corporate bonds:

- An exchange-traded fund from iShares, the iBoxx Investment Grade Corporate Bond Fund ;

-the T. Rowe Price Corporate Income Fund, which invests in the "BBB-" to A-rated corporate debt;

-and Vanguard Long-Term Investment Grade, which invests in not quite as high quality bonds.

For those who want to take on a little more credit risk, Jones recommended Loomis Sayles Bond, which declined 22.1 percent in 2008; however, Morningstar has said it is poised for a rebound. The fund, which is outperforming its peers over the last five years annualized by 0.48 percent, is managed by bond luminary Dan Fuss.

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