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US Corporate Bonds Begin to Look More Enticing

Investors hungry for returns may give long-shunned U.S. corporate bonds another look if commodities see their first weak quarter after a year of dizzying growth.

As oil, metals and grains prices hit multi-month lows, reversing this year's record highs, analysts said U.S. non-government bonds could become a draw for investors shifting money out of commodities to avoid volatility in the sector.

Stocks are a competing destination for money flowing out of commodity markets, but bonds may offer steadier returns provided that inflation starts to moderate as global economic growth slows, analysts said.

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"There are a lot of opportunities out there in the fixed income market. Money has to go somewhere to these undervalued sectors within fixed income," said Sean Simko, a fixed-income portfolio manager with SEI in Oaks, Pennsylvania.

Simko said he expected bonds overall would perform better if commodities were to continue their sell-off and if U.S. consumer inflation slipped from 5 percent year-over-year now to about 3 percent.

However, the Treasury market, already "fairly valued" because of the safe-haven bid flowing from riskier assets during the year-long financial crisis, may not be a chief beneficiary of any flows out of commodities, Simko said.

Yielding about 4 percent, the benchmark 10-year Treasury note is 1 percentage point below inflation, whereas corporate bonds battered by the credit crisis offer much higher yields to compensate investors for the risk issuers may default.

The average investment grade corporate bond yields 6.57 percent, according to Merrill Lynch data, with its spread over Treasuries just 5 basis points shy of an all-time high hit on March 20 after the collapse of investment bank Bear Stearns.

There are pockets of opportunities and value in such U.S. investment-grade corporate bonds, Simko said.

So called "junk" corporate bonds with credit ratings below investment grade could also become a draw, analysts expect.

U.S. high yield bonds on average yield about 11.53 percent, the highest since 2003.

"Some money will migrate into high-yield because unlike most of their other bond brethren, high-yield bonds tend to thrive on slightly higher inflation," said Jack Ablin, chief investment officer at Harris Private Bank in Chicago.

High yield, or speculative grade, bonds have high default risks.

They now offer interest rates of about 8 percentage points above safer government issues.

Such bonds have fallen out of favor with investors since the U.S. credit crisis erupted a year ago.

The weakening American economy has further eroded credit quality of speculative grade U.S. corporate bonds.

U.S. high yield bonds have delivered a negative total return of 3.26 percent year-to-date, versus a gain of 2.19 percent for 2007, according to investment bank Merrill Lynch.

If the bull market in commodities continues to falter and inflation moderates, corporate bonds that have already priced in a lot of economic weakness may tempt a few investors back.

"I can't promise that you won't lose money in high yield or that stocks have reached a bottom, but you are better off in high yield than in equities," because of the risk stocks could fall more steeply, Ablin said.

"If nothing happens, which is the best scenario, you are clipping an 8-to-9 percent coupon" from junk bonds, Ablin said.

Since mid-July, energy, metals and agricultural prices havevernment-supported mortgage securities to junk bonds.

Bill Gross, chief investment officer of Pacific Investment Management, said on Tuesday that because of government intervention to underpin the mortgage finance giants, he favored debt from Fannie Mae and Freddie Mac over high-yield bonds.

Investors may take more time to gauge the effects of the long-running credit crisis on the credit quality of companies and banks' debt and the stock market's performance before venturing back into corporate bonds, Simko said.

They may also wait to see if commodities stage a late year rally, he added.