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Bonds: Great for Companies, but Not So Much for Investors

Just because companies are utilizing extremely advantageous conditions to issue debt at breakneck speed, that doesn't mean investors ought to get on board.

NYSE Trader
Photo: Oliver Quillia for CNBC.com
NYSE Trader

What's good for those companies—low borrowing costs and a receptive market—is not necessarily good for investors, particularly those looking for a payback on the risk they take to own the debt.

In many cases, then, investors hunting for yield might be just as well buy dividend-paying stocks rather than paying top-dollar for corporate debt.

"The whole interest rate game just scares me," says Nadav Baum, executive vice president at BPU Investment Management in Pittsburgh, Pa. "I would much rather own the pseudo-debt or buy these big dividend-paying companies that act like surrogate debt."

Several cross-currents are working in the debt space that make the choice for debt issuers fairly easy but more difficult for debt buyers.

Large companies such as Google , Norfolk Southern and Walt Disney stepped into the bond market recently, and have been part of a larger trend that has seen corporate issuance in 2011 far eclipse the previous year.

These are companies that hardly need the cash but are taking advantage of the low rate environment to build positions.

US companies have issued $147 billion in investment grade debt this year, with 10 percent of the total coming in this week alone, according to Dealogic. Through April, companies globally had issued $335 billion in investment grade debt, far outpacing the $250 billion for the same period in 2010.

The reason for the flurry of activity is both the existence of low financing costs and the reality that the trough for interest rates has probably come and gone as the Federal Reserve ends its monetary intervention.

Once the central banks start backing away from its quantitative easing program, rates are likely to drift higher and prices will move lower.

Investors not holding bonds to duration—as is the case with most of the hugely popular bond funds in the mutual and exchange-traded markets—could get stung.

In that kind of environment, Baum thinks investors are better off holding stocks that pay dividends from solid companies whose share prices aren't subject to sharp volatility—examples being Kraft and Philip Morris .

"When rates go up, and if they up for the right reason because of economic growth, the equity positions should do very well because the companies are growing," he says. "I would much prefer to own the high-quality equity side as opposed to the corporate bond side."

Yields on top-quality 10-year corporate bonds have tumbled to 3.55 percent—down from 3.90 percent just a month ago.

The flurry of issuance, then, isn't hard to understand.

"These low yields are just one sign of the bond market’s cheery mood," Charles Rotblutt, vice president of the American Association of Individual Investors, said in an analysis. "Corporations are finding plenty of buyers for their debt, and many offerings have been completed this week. Taking advantage of the low interest rates is good for a company’s bottom line, though it does raise bondholders’ ire."

Rotblutt found that more than 800 stocks in the Standard & Poor's Composite 1500 have paid a dividend over the past three years at an average of 2.25 percent. At the same time, five-year high-grade corporate debt is yielding just 1.92 percent.

Even on the opposite end of the spectrum, yields for junk bonds have fallen to historic lows, with the iShares Barclays US Corporate High Yield index at 6.68 percent "which isn't much when you consider the risk of default," Rotblutt says.

Not surprsingly, high-grade issuers have rushed to the market as well, issuing $160 billion this year—already half the total of 2011—as lower-rated companies refinance more expensive debt already on their balance sheets.

Rotblutt found that 50 members of the S&P 1500 yield more than 5 percent, though he noted that most are in either real estate investment trusts, utilities or telecoms, limiting diversification opportunities.

Investors, then, need to be wary of where they go in corporate bonds.

Marilyn Cohen, who runs Envision Capital Management in Los Angeles, advises clients to beware of corporate debt if it's used for one of these purposes: to pay for special dividends; to pay for increased dividends; for repurchasing shares from companies with existing cash and cash flow; new debt for share repurchases; for takeovers that use cash and equity; and takeovers with new debt.

Some, though, are even more cautious, particularly those who feel the end of Fed easing will squeeze bond positions.

"The longer this goes on the higher the risks as we approach the change," says Bill Larkin, portfolio manager at Cabot Money Management in Salem, Mass. "We know that the Fed has to make a change at some point. The market is starting to make an indication that change is coming."

Larkin advises clients to build cash positions to deploy after the market's position becomes clearer.

"I look at this as a special indicator of caution," he says of the flood in debt issuance. "When they're selling in such large numbers, they're looking at a big market opportunity. As a buyer, I need to be careful."