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Corporate Bonds Looking to Break Through in New Year

Friday, 31 Dec 2010 | 1:05 PM ET

Though they delivered mixed returns in 2010, corporate bonds are getting an increased amount of attention for 2011 as US companies look to stronger growth prospects and the hunt for yield intensifies.

While stocks and commodities were surging through the year, corporates, particularly investment grade, posted only modest returns.

The iShares iBoxx Investment Grade Corporate Bond exchange-traded fund delivered a comparatively timid 4 percent gain for the year, reflecting aversion to the group particularly in the fourth quarter, when virtually all fixed-income instruments took a beating.

But recent forecasts from several firms have been considerably bullish on corporates, even though the trend still appears away from investment grade and more towards some of the lower-rated emerging market and BBB-rated US debt.

"[W]e no longer expect risk appetite to wane to the point where it more than offsets the impact of a renewed drop in government bond yields," John Higgins, senior market economist at Capital Economics in London, wrote in a research note to clients. "If, as we fear, the US recovery peters out and the economy endures a Japan-style 'lost decade,' then corporate bonds should do considerably better than equities over time."

The Capital forecast, to be sure, is predicated on a much weaker stock market performance than consensus. The firm believes the Standard & Poor's 500 will post a slight loss in 2011 and finish around 1,200, which is well below most analyst estimates of 1,400 and beyond.

But there are more reasons to like corporates than just as an alternative to equities, even though many market experts are anticipating higher interest rates in the year ahead.

Issuance is expected to be well below the flood of $711 billion to hit the market in 2010, according to IFR Markets, but the climate should still be healthy, pushed by mergers and acquisitions as well as leveraged buyouts.

Corporate cash positions also are likely to be strong, with US companies raking in $1.64 trillion in the third quarter, the highest since the peak of $1.66 trillion in the third quarter of 2006, according to Deutsche Bank.

Capital projects Treasury yields to reverse their fourth-quarter surge, dropping to as low as 2.50 percent for the benchmark 10-year note. Spreads also are not expected to narrow dramatically and likely will stay in line with historical averages.

While the 12 percent 2010 gain for BBB-rated corporates was about a third of what they generated the previous year, Higgins said the firm "expects further gains in 2011."

Outside the US, the outlook is positive as well, according to analysts at Bank of America Merrill Lynch.

In particular, emerging markets—which include the Brazil, Russia, India and China BRIC countries as well as other larger but still-developing nations—will be strong thanks to low expected default rates and tight spreads.

"With their economies growing well above the pace seen in the developed world, inflation rates somewhat high but not spinning out of control (a credit positive), relatively strong balance sheets, and competitive yields, EM corporate bonds should remain a preferred destination for new investor flows," BofAML said in a research note to clients.

The firm recommends single-B and triple-B notes as the best opportunities in emerging markets. Double-B notes "appear relatively rich, compared to US counterparts. Generally speaking, we maintain a down-in-quality positioning recommendations in credit for 2011."

Winners & Losers of 2010: Bond Market, Bernanke
High Treasury rates are a winner of 2010, while Bernanke and his QE2 policy fall in the loser column, according to CNBC's Larry Kudlow. Vince Reinhart of the American Enterprise Institute and Joe Calhoun of Alhambra Investments weigh in.

Lower-quality notes offer not only higher risk but also potentially higher returns than their more lackluster higher-grade counterparts. At the same time, most of the recommendations for corporates are toward shorter-term securities, as inflation remains a threat to long-term fixed-income instruments.

Risk management will be critical, especially in the European Union, where much of the sovereign debt remains on shaky ground after a tumultuous 2010.

"All in all, we maintain a positive view on EM economic growth, credit performance in general, and down-in-quality positioning, which to a great extent is based on the assumption that European sovereign debt issues will remain contained," BofAML said.

"This is not to say that we expect them to go away any time soon either, only that the situation does not spin out of control there, and larger economies such as Spain and Italy do not have to resort to the (bailout) safety net."

While the firm sees positive growth for US corporate debt, it believes emerging markets will fare better.

EM high yield is estimated to gain 11.8 percent, while investment grade should gain 4.6 percent. That compares respectively to 10.3 percent and 2.5 percent in US corporate debt.

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