Time to Be Picky About Corporate Bonds

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Talk about late to the party. Investors looking to invest in corporate bonds may get tired of hearing about how returns in 2013 won't match those of 2012.

Investors must temper their expectations, then, said Kathy Jones, fixed-income strategist for the Schwab Center for Financial Research. All corporate bond returns will be modest — in the single-digit range, she added.

Investors have poured money into all kinds of bonds, pushing yields down to near-record lows. For example, the Morningstar Corporate Bond Index recently registered its lowest yield, 2.58 percent, for investment grade bonds since the index's inception in 1998. Average yields usually hover around 5.41 percent.

These low yields will drag down bond performance in 2013.

The looming "fiscal cliff" and a sluggish economy may throw ringers into bond performance, too.

Though Schwab and several other firms have forecast that Congress will probably reach a deal—avoiding the most severe spending cuts and tax hikes that could trigger a recession—some corporate bonds are still vulnerable to the slow economy and are already richly priced, such as high-yields.

"So there aren't any bonds we can pound the table about, since they've all had a strong run," said Jones.

There will also be fewer new debt issues, Jones predicted, translating into more money chasing even fewer bonds. The corporations that could issue debt, especially investment-grade quality, have already cashed in on low rates and strong investor demand, refinancing debt and extending maturities.

Over half of the proceeds were used to pay off existing debt, said Eric Takaha, director of corporate and high-yield bonds at Franklin Templeton. Bond credit quality, he adds, is still much better than pre-crisis levels, which is good news for investors.

So, even if 2013 looks to have solid fundamentals, it will be a bond pickers' game, said Takaha. Already strong sectors like housing and financials won't necessarily outperform the overall market. (Read More: Fixed Income Outlook.)

"Individual selection will matter," said Takaha.

Mutual Funds Vs. ETFs

Anthony Valeri, fixed-income strategist at LPL Financial, likes investment-grade bonds issued by financial companies. Despite a rally this year, they're still cheaper than other bonds, he says.

Avoid buying long-term investment-grade bonds, though, Valeri said. Stick to three- to five- year maturities.

"The extra returns for longer maturities aren't worth the interest-rate risk you take," he said.

Valeri also prefers bond funds over exchange traded funds, or ETFs, as investment vehicles.

Bond fund managers can hold bonds that ETFs can't, he said, such as less liquid ones with higher yields. Conversely, ETFs usually mirror a bond index, and may not be actively managed.

So, he advises that investors use ETFs only for immediate liquidity or lower dollar investments.

Jones agrees. When you look at the broad bond indexes, they aren't as diversified as people think, she said, adding: "So, I'm not a big fan of index tracking."

For example, the bellwether Barclays Capital U.S. Aggregate bond Index sounds like it's exposed to all kinds of bonds, she said, but about 80 percent of the index is composed of bonds backed by the U.S. Treasury. Corporate bonds make up only 20 percent.

"So investors think they have broad exposure, when they don't," said Jones.

The upshot is that bond funds have outperformed the broad indices in 2012. For the first nine months of 2012, taxable bond funds beat the Barclays index by almost 3 percentage points.