Corporate Bond Investing in 2011: Strategies and Pitfalls

Higher rates could make corporate bond investing a trickier prospect in 2011.

Joel Levington, managing director of corporate credit at Brookfield Investment Management, said one strategy is to fish for winners among the lower-rated investment grade bonds.

Corporate Bond

"In a market that's searching for yield, one way to play in the investment grade arena is to look for sectors you think have a benign to favorable prospect, and then look down in the ratings scale.

"So instead of getting the AA credit, you might want to look at BBB instead to get more yield. One sector where I think that fits well is technology, where the higher rated players are names like Hewlett-Packard , Cisco or IBM and some of the lower-rated names might be Agilent, Tyco Electronics and Intuit," he said.

Levington said that strategy worked well in 2010, when the return on investment-grade bonds was about 10 percent. He sees a return of only 2 to 3 percent for 2011.

He pointed to the example of Cisco — with a high A rating — which recently issued a 10-year, currently yielding 3.86 percent. That compares to Tyco Electronics , which issued a bond with similar maturity currently yielding 4.75 percent. Tyco has a BBB rating from all three rating agencies with a positive outlook, so there is room for upgrades.

"You can get high ratings vulnerable to downgrade, or low ratings that are upgrade candidates. To me, I'd rather be at the low end going up, rather than high end going down," Levington said.

Another example is health care, where big pharma has underperformed compared to some sectors, like pharmacy distribution. "You've seen an increase in health-care distribution so we've taken Cardinal Health , for example, [which] has been upgraded during the year. It has positive outlooks from two of the rating agencies, meaning it could get upgraded again in 2011," he said.

Cardinal's recently issued 10-year bond is currently yielding 4.7 percent. Fitch and S&P rate it high BBB with a positive outlook, and Moody's rates it low BBB but stable. Compare it to Merck , which has an average low AA rating. Merck's 10-year is at a 4.06 percent yield.

Levington said the stock performance is also a clue. Merck's stock is down nearly 1 percent year-to-date, while the S&P 500 is up more than 12 percent.

"I tend to think there's a circular reference that happens with companies. Once their fundamentals and their prospects start to stall, that tends to lead to stock underperformance and that tends to lead to management doing something about it, and that tends to be financial engineering, as in a dividend or share purchases," he said. Merck recently acquired Schering-Plough.

In 2010, there was $728.9 billion in investment-grade corporate bond issuance, up from $719.0 billion the year earlier, but well below the 2007 peak of $989.9 billion, according to Thomson Reuters IFR.

The year 2010 did make the record books for all-time low yields on some new issues. According to IFR, a Colgate-Palmolive 5-year issued in October was yielding 1.375 percent, and a Wal-Mart 3-year issued in late October had a yield of 0.75 percent. A Johnson and Johnson 10-year, issued in September, was yielding 2.95 percent, and a 30-year Microsoft bond came to market yielding 4.5 percent in September.

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