Can Bonds Score a Repeat Performance After Big 2009?

The bond market will have a tough act to follow for 2010, and many investment professionals think this year's stellar returns will not be duplicated.

But any investment class would have a tough time with delivering an encore for such a performance: While stocks got all the sexy headlines during 2009, bonds were stars in their own right.

As such, even though bonds, particularly the high-yield variety, likely won't repeat this year's gains, there will be areas of growth for investors looking both for return and to protect principal.

Jeff Cox
Senior Writer
CNBC.com

"Things won't be quite as profitable for the bond market as 2009," said Bill Walsh, president of Hennion & Walsh in Parsippany, N.J. "People who are looking for safety and income and definite cash flow, it could be a benefit to them. You're definitely going to have an appetite for safety."

Investors across an array of bond choices had a nice year to say the least, with the Morningstar Core Bond Index up 6.5 percent.

Even as the equity markets were gaining 20 percent, multiple areas of the bond market saw yields easily eclipse that.

Another Good Year for Corporates

Tops in the field were high-yield corporate bonds, which returned nearly 55 percent on the year as credit spreads tightened and offset the ever-widening yield curve in Treasurys. Corporate bonds as a group gained 18.3 percent, according to Morningstar.

Most analysts see corporates continuing to perform strongly in 2010, primarily due to forecasts of declining defaults and the ability to go to market to raise capital.

Analysts at Bank of America-Merrill Lynch are projecting the default rate to fall to 4.6 percent, while UBS forecasts a similar drop to the 5 percent to 7 percent range from 2009's 12 percent.

Though such a gaudy return would be hard to replicate, analysts still see a robust year for high-yielding corporate bonds.

"We expect more companies to raise public equity financing to help repay their debt and delever balance sheets, providing a favorable fundamental backdrop for the (high-yield) market in 2010," BofA-Merrill analysts Jeffrey Rosenberg and Oleg Melentyev wrote in a note to clients. "The improvement in HY issuer fundamentals and continuing favorable liquidity conditions are going to translate into significant improvement in default rates."

UBS was a bit less sanguine about the prospects for corporates but nonetheless optimistic, noting the changes in upgrades and downgrades from industry rating agencies.

Where the ratio of upgrades to downgrades was 1-to-9 during the worst of the credit crisis, that number has dropped to 4-to-6 and should be even-up in 2010, UBS said.

"While much of the spread compression associated with an unwinding of the most acute phase of the credit crisis has been realized, corporate bonds will continue to benefit from a general improvement in overall credit conditions," the firm wrote in its 2010 outlook. "The vicious cycle of a crisis-driven surge in corporate defaults as companies were unable to roll over financing is now giving way to a virtuous cycle of declining defaults as credit markets continue to normalize."

Other leading performers in 2009 included emerging market sovereign bonds (up 27 percent), Treasury Inflation-Protected Securities, or TIPS (13.3 percent), investment grade corporates (19.7 percent) and municipals (14 percent).