Dec. 2, 2011, 2:25 p.m. EST
Article from Market Watch
Find value in lower-rated firms with strong cash flow
By Deborah Levine, MarketWatch
NEW YORK (MarketWatch) — Some top money managers are recommending that investors shift a bit more into bonds and out of stocks as rising yields and a slower economic growth outlook make fixed income more attractive.
But U.S. Treasury bonds offers paltry yields nowadays, and the income from corporate issues isn’t much higher. Income-hungry investors are left with the unpleasant choice of taking more interest-rate risk by holding longer-term bonds or moving down in credit quality.
Many bond-market experts say corporate bonds, especially those at the lower end of the investment-grade universe, are a reasonable option. Only a handful of U.S. firms carry the highest-possible AAA credit rating, with a large number of issues two levels lower in the single-A range.
By moving down the ladder a little more to companies rated BBB, investors can find credits that are still investment grade but yield noticeably more. That’s the point where bond strategists are looking for A-type financial strength. Read more: How to own a triple-A portfolio.
“U.S. companies are in pretty good shape and have done a nice job of cutting jobs and generating cash,” said Lon Erickson, a portfolio manager at Thornburg Investment Management. “That’s a pretty good environment for fixed-income investors. Some BBB-type names are more interesting because they come with a little [yield] spread.”
Company cash counts
This circumstance is a byproduct of the economic recession. U.S. companies have continued to shore up their balance sheets through the downturn and have been frugal even when seeing signs of recovery.
“If there is anything out there that is remotely close to ‘recession proof’ it is corporate balance sheets,” said David Rosenberg, chief economist and strategist at Toronto-based asset manager Gluskin Sheff + Associates, in a recent report to clients. “Be selective and identify those entities that have a single-A balance sheet but pay out a BBB yield.”
As a result, many firms have both ample cash on hand and good cash-flow streams — two key criteria when buying corporate bonds, said Hans Olsen, head of Americas investment strategy at Barclays Wealth.
If the economy stays out of recession and corporate profits remain strong, “as a bondholder, you look pretty good,” he said. “A number of firms are generating excess cash so without any problem can get their debt paid.”
Bonds with ratings between Aaa and Baa3 ratings from Moody’s Investors Service, or AAA to BBB-minus from Standard & Poor's, are considered investment grade.
At the highest end of the rating scale, companies have strong market positions, a stable or growing business, good corporate governance and impeccable liquidity, said Mark Gray, managing director in the corporate finance group at Moody’s.
“They’ll have enough cash, cash-flow or external liquidity to get through a couple of years,” he said.
Some examples of AA-rated companies are Wal-Mart Stores Inc. WMT -0.89% , 3M Co. MMM -0.67% and General Electric Co. GE +0.19%
Companies rated Baa may be in a more cyclical business, but still have relatively stable margins, Gray noted.
“We expect them to have the ability to cut back on spending if we entered a rough, recessionary period,” he said. “You wouldn’t expect an investment-grade company to have to run out and sell assets to make ends meet.”
Examples of Baa-rated issuers include media companies Time Warner Inc. TWX +0.58% , Comcast Corp. CMCSA +3.50% , and CBS Corp. CBS +0.55% and railroads CSX Corp. CSX +1.10% and Union Pacific Corp. UNP -0.23%
Several big asset management firms also see opportunities for yield pickup in below-investment-grade debt as the outlook for U.S. and global growth becomes clearer.
‘Adding weight to junk’ allocation
“I have an optimistic view of the world,” said Phil Orlando, chief equity market strategist at Federated Investors and chairman of the money management firm’s asset allocation committee. “We had a very defensive allocation over the summer, but we’re at a point where we feel we have better visibility in terms of the direction of the economy, and we think Washington and Europe are moving in the right direction but the market isn’t giving them credit for it yet.”
“We’ve added weight to junk bonds and to corporate” and slightly longer-term debt, Orlando said. Those will likely return more than Treasurys, he predicted.
Corporate bonds have returned 5.3% so far this year, according to an index compiled by Bank of America Merrill Lynch. The effective yield on the index is 4.09%.
High-yield debt, meanwhile, has returned 2.2%, according to another BofA Merrill index. But the effective yield is 8.87%.
Treasurys have performed much better, though yields are low. The sector has returned 8.5% this year, with an effective yield of 1.15%.
Credit and dues
It’s no secret to anyone trying to live on a fixed income that bond yields aren’t what they used to be, and probably won’t be for awhile.
“We’re in this stifling desert of no yield,” said Marilyn Cohen, president of Envision Capital Management, a bond-portfolio manager in Los Angeles.
With corporate debt, “2.5% or 3% is the old 5%,” she said. Or worse. Cohen pointed to a double-A-plus rated tranche of Microsoft Corp. MSFT -0.16% debt due in 2016 yielding 1.14%. In contrast, the company’s stock yields about 3.2%.
Accordingly, for corporate bond investors, she said, “A decent balance sheet going down in credit quality that isn’t as pristine as you may be used to is the way to fly.”
The broadest bond-investing strategy involves mutual funds and exchange-traded funds.
“A highly-rated, well-diversified bond fund or exchange-traded fund is the way to go,” said Paul Zemsky, ING Investment Management’s chief investment officer of multi-asset strategies. Most keep the average credit rating of the fund close to their benchmark index, he noted.
Index-tracking ETFs tend to have lower expenses than actively managed funds, and their holdings are more transparent. Some examples of corporate-bond ETFs include Vanguard Long-Term Corporate Bond Index ETF VCLT +1.44% , which recently sported a 4.9% yield, Pimco Investment Grade Corporate Bond Index ETF CORP +0.30% , with a yield of around 3.5%, and SPDR Barclays Capital Intermediate-Term Credit Bond ITR +0.42% , recently yielding 3%.
It’s riskier of course to buy individual credits unless you understand the finer points of bond analysis, or assign your portfolio to someone who does.
Cohen actively searches for BBB or BB companies that are flush with cash. One issuer she favors is DirectTV Group Inc. DTV +3.32% , which she calls a “best of breed” triple-B credit that both Cohen and her clients own. The company’s bonds maturing in 2016, for instance, yield close to 3%, she said.
Cohen also owns the debt of BB-rated BE Aerospace Inc. BEAV -0.05% , which manufactures aviation products. As an example, she points to its 8.5% coupon bonds maturing in 2018 that are callable in July 2013, meaning that the company can retire the debt early after that date. Meantime, bondholders pocket a yield to call of almost 5.9%.
Other lower-grade corporate credits on Cohen’s list include BB-plus Tesoro Corp. TSO +0.39% , BB-rated Royal Caribbean Cruises Ltd. RCL +1.01% , BB-plus Ford Motor Co. F +0.09% and Goodyear Tire & Rubber Co. GT -0.21%
“They’re not bargains,” Cohen said. “But these are absolutely better returns than double-As and single-As.”
Stretching for yield
For the highest-yielding corporate bonds, investors have to delve into the world of so-called junk bonds. Again, the best way to diversify across this area, where default risk is part of the trade-off, is through mutual funds and ETFs.
Olsen at Barclays Wealth said the return potential for high-yield bonds nowadays outweighs the risks.
“While equities are still cheap, in certain credits in the high-yield space you can get total returns that are equity-like while senior in the capital structure and sometimes secured,” he said. Read story on signs to watch before buying junk bonds.
Moreover, Olsen noted that high-yield bonds offer better risk-adjusted returns because what really matters is not earnings growth but whether a company generates cash and earnings to cover its interest payments. When you add the price gains to the coupon, he added, high-yield debt can return in the neighborhood of 12%.
But some strategists caution against venturing too deeply into this dicier area of the bond market. High-yield debt can trade more like stocks than bonds, and can falter along with stocks if global investors lack confidence in a recovery.
So yield players shouldn’t be too quick to swing for the fences. Said Tim Knepp, chief investment officer of Genworth Financial Wealth Management: “Most clients in this environment are fairly guarded in what they’re trying to accomplish.”
Deborah Levine is a MarketWatch reporter, based in New York.