Missed Opportunities in Corporate Bonds

Two essential questions face investors who are trying to position their portfolios for the next few years or longer-term:

* What kind of returns do you expect, on average, from stocks, bonds, real estate, short-term cash accounts and other major asset categories?

* How much does your portfolio need to earn to get you where you want to go?

Some financial advisors say the order of those questions should be reversed: If you’re struggling with asset-allocation decisions, they say, first think about the amount of money necessary to fund your life, and lifestyle, and then map out an investment mix that could generate the returns you need.

The issue of basic portfolio structure has become critical for most investors over the last two years as stock prices have plummeted. Before the bear market began, many people simply opted to shovel all of their savings into stocks, trusting that Wall Street would continue to produce superior returns. Now the outlook for equities is much more sober.

Robert Rodriguez, veteran manager of the Los Angeles-based FPA Capital and FPA New Income mutual funds, believes that stock market returns will average 5% or less annually over the next five years, about half the historical average return, as the market struggles to recover from the excesses of the late 1990s.

Rodriguez is more pessimistic than many of his peers. But even if equity returns turn out to be between, say, 5% and 8% in the next five years, investors should consider how that would compare with potential returns on other assets--in particular, corporate bonds, the yields on which are tempting because they are historically high compared with yields on Treasury securities and bank CDs.

For the bulk of almost any portfolio, the choice is between assets that may produce capital gains (the primary reason most people own stocks) and assets that do produce income (bonds, bank CDs, etc.).

In the late 1990s it seemed that stocks only went higher, and substantially so each year. In that environment, when earning 20% or more annually in equities was a slam dunk, there was little appeal in the much lower yields provided by bonds and CDs.

But now the tables have turned. Investors have a greater appreciation of the risks involved in owning stocks. Despite the market’s rebound of the last five weeks, there is no assurance that the longest bear market in a generation ended in late July. And even if it did, the issue is what level of returns stocks can generate from here, versus what’s available on other investments.

Any asset allocation decision involves guesswork and risks, of course. Which is why many financial advisors start with a potentially simpler question: What level of portfolio return would meet your goals?

If earning just 4% a year on your money for the next 10 years would allow you to live comfortably and fund future obligations, there’s a simple solution that involves none of the risk of owning stocks: Just buy 10-year Treasury notes, which now yield about 4.2% annually.

You’d be assured of getting back the face value of the bonds if you hold them to maturity, because nothing is safer than Treasury securities in that regard. But there is risk, nonetheless. If inflation were to rise over the next decade, your fixed return could be badly eroded.

What’s more, if you had to sell your Treasury notes before maturity, you might get much less than face value, depending on the level of market interest rates at that moment.

Seeking Safety

Many investors this year have decided that the long-term safety of principal afforded by Treasuries outweighs the inflation risk. That’s apparent because demand for Treasuries--and mutual funds that own government bonds--has pushed yields on those securities to 40-year lows in the last few weeks. Those yields have since risen somewhat, but they’re still extraordinarily depressed.

Similarly, the surge in cash inflows to federally insured bank savings accounts this year is a powerful sign that many Americans now crave safety of principal above all else.

Not FPA’s Rodriguez, however. He can own a mix of bond types in his New Income fund, and his view of Treasuries is unequivocal: “I find no value in high-quality bonds, especially Treasuries,” he said. “I will not commit capital at these levels.”

Individual investors should be casting a similarly wary eye on super-safe assets, if the question is whether to buy more, many financial advisors say. If earning 2% on bank savings accounts, or 4% on long-term Treasuries, isn’t going to get you very far toward meeting your financial goals in the long run, you’ll have to consider whether it’s a better time to be adding higher-risk assets that may produce higher returns.

There are stocks, naturally. But some Wall Street pros believe that investors are missing a great opportunity in corporate bonds.

Yields on investment-grade corporate bonds have declined this year, but the “spread” between corporate yields and Treasury yields remains near record levels.

The Lure of Junk

A Moody’s Investors Service index of the average annualized yield on AAA-rated corporate issues was at 6.37% late last week; on BAA-rated issues (still considered investment-grade, but lower down the quality ladder) the average yield was 7.58%.

On corporate junk bonds--those considered below investment grade--yields remain near their highest levels since the recession of 1990, though buyers jumped into the junk market last week, driving yields down a bit. The average yield on a junk index tracked by KDP Investment Advisors fell to 11.63% on Friday, down from a 52-week high of 12.28% set on Aug. 14, but still far above the 8% to 9% yields that prevailed on junk in 1997-1998.

Why are investors so skittish about corporate bonds? There are a number of reasons, but the most obvious is concern that the economy might fall back into recession. Given that junk bond defaults already are running at record levels in terms of the dollar volume of securities, investors fear that another wave of defaults could be ahead if the economy falters.

Yet for investors who are willing to bet on equities at this point--which is, after all, a bet on a better economy--corporate bonds may make as much sense, or more.

With bonds, assuming the issuing company can pay its bills, you’re at least assured of a certain annual income return through the bond’s maturity.

Like all bonds, corporate issues face the risk that their fixed returns could be eroded by inflation. But those risks are lower with corporate issues than with Treasuries, for the simple reason that corporate yields are much higher.

Cautious Approach

There’s also a potential kicker with corporate issues: If the economy is indeed recovering, the prices of many depressed bonds should recover as well.

Jack Malvey, fixed-income strategist at brokerage Lehman Bros. in New York, said he’s advising clients to begin committing money to corporate bonds, though slowly, because he remains worried about the economy and the risk of an outside shock, such as a U.S.-Iraq war. But he believes investors should definitely be looking in the direction of corporate issues.

The challenge for investors is in locating either individual bonds or bond mutual funds that they’re comfortable with. For help, consider subscriptions to two data vendors: www.incomesecurities.com (for individual bonds) and www.morningstar.com (for funds).

Tom Petruno can be reached at [email protected]