Published: Tuesday, 4 Aug 2009 | 5:06 PM ET

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U.S. corporate bonds, after rallying nearly nonstop since March, may be poised for a pullback before year end.

Corporate Bonds

Corporate bonds have rallied since government stress tests on banks removed fears that another major financial company would collapse. Eager to profit from a credit market recovery, investors have poured cash into corporate bonds, attracted by record high yields reached during last year's credit crisis.

The rally, however, has cut yields by more than a third, making it harder to find value even as uncertainty lingers over companies that issue corporate debt.

"I don't think at this point in time there's a lot of reward for the risk you are taking in the corporate bond market in any sector," said Dan Vrabac, portfolio manager for the Ivy Global Bond Fund in Overland Park, Kansas.

Second-quarter earnings, which confounded investors' initial fears and turned out much better than expected, have given a fresh wind to the corporate bond rally. But earnings are still down 29 percent from the year-ago period for the 370 S&P 500 companies reporting so far, according to Thomson Reuters data.

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"Really there's no suggestion that fundamentals are getting any better right now, which means that all the trading is based on expectations and hopes," said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott in Philadelphia.

Stocks Beat Bonds in July

Demand has been so strong that traders are having a hard time finding enough corporate bonds to sell, especially as a summer lull in bond issuance crimps supply. Cash flow into the market has been relentless as investors chase returns that have averaged 13 percent year to date, according to Merrill Lynch indexes.

"As some people enjoyed huge returns over the course of the last six months, they're starting to realize those returns just can't be repeated," LeBas said. "I think that's where a lot of the selling is probably going to originate."

Investors could begin taking profits later this year to protect the year's stellar gains, some strategists said. The stock market also could begin to compete with corporate bonds for cash, according to a recent Bank of America Merrill Lynch research note.

July marked the first month this year that stocks' returns beat corporate bonds, with the S&P 500 climbing 7.4 percent for the month, while the bank's note to clients pointed out that the monthly gain was just 4.6 percent for the best-performing corporate bonds, those with BBB ratings.

After devastating stock market losses last year, investors had been shifting out of equities into less risky corporate debt, but that move could reverse if July's performance trend persists, the bank said.

Some investors are still finding attractively priced corporate bonds.

"There's more opportunity in lower investment grade or just below," said Keith Springer, president of Sacramento-based Capital Financial Advisory Services. He said he has been buying some short-dated Sallie Mae notes with yields as high as 10 percent and bonds of Marshall & Ilsley, a Wisconsin bank that benefits from government support.

'Bubble' Era Yields Return

Yields on better-quality corporate bonds are looking much less attractive than they were just a few months ago, especially relative to U.S. Treasurys. The yield gap between Treasurys and some highly rated corporate debt is now as skimpy as it was during the credit "bubble" years of 2006 and early 2007.

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[CL  Loading...      ()   ], for example, sold six-year notes last week at a spread of 67 basis points over Treasurys, close to the 64-basis-point spread it paid on 10-year notes in November 2006, according to Bank of America.

The collapse in spreads is not reflecting the risks in the economy, said Vrabac of the Ivy Global Bond Fund. Over-leveraged financial companies and consumers are still retrenching, which means the economy will be growing at a much slower rate than the market perceives, he said. The U.S. job market is also too weak to support consumer spending and strong economic growth, Vrabac said.

"Without the consumer, which is two-thirds or more of the economy, I don't see how you can get (the economy) growing at the type of levels that the market is discounting today," he said.

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