SERIOUS MONEY:The cautious investor need look no further than investment-grade corporate bonds, writes Charlie Fell
INVESTORS WILL be relieved that the downward spiral in prices apparent across most asset classes in recent weeks appears to be coming to an end. The pain was felt far and wide last month as global stock prices recorded their largest monthly decline since the MSCI index was introduced in 1969, commodities suffered their worst month since the CRB index was launched in 1956, and gold endured the biggest monthly loss since 1983.
There was simply no place to hide as widespread pessimism saw investors withdraw from risk assets of all varieties.
Recent price action, however, has given cause for hope. Stock prices have registered double-digit gains in the face of dismal economic data - from four-decade lows in consumer confidence and plunging auto sales to an alarming deterioration in the outlook for the manufacturing sector.
It is clear that stock market valuations are at their most attractive levels in years but in the search for cheap risk assets, the more cautious investor need look no further than investment-grade corporate bonds. Extreme risk aversion has seen investors in high-quality corporate debt suffer double-digit losses in the year to date, which has caused yields to jump to more than 9 per cent or 5½ percentage points above that available on 10-year treasuries.
These unprecedented levels are 40 per cent higher than the peak spread in 2002 and even above the historical average spread available on high-yield bonds. Investors are being offered equity-like returns with bond-like risk.
Even a modest narrowing of spreads would see investors earn returns of roughly 15 per cent in the year ahead.
The yield spread on corporate bonds should begin to narrow once stock market volatility begins to drop from the terrifying levels of recent weeks.
Investors in corporate bonds can be viewed as owners of default-free treasury debt of comparable maturity who have issued an option to default to the underlying company's shareholders. The value of this option to default moves in tandem with the underlying stock's volatility. An increase in price volatility raises the probability of default and thus option value, causing the bond price to decline and the yield to rise. Not surprisingly, this effect combined with the flight-to-quality that accompanies extreme levels of stock market volatility causes yield spreads to soar but they begin to decline once price volatility returns to more normal levels.
There is no reason to believe that this will not happen in the months ahead once a more rational market environment returns.
Investors may be concerned that yield spreads will remain elevated or even deteriorate further due to the ongoing freeze in the credit markets combined with a sharp recession that causes severe weakness in corporate profitability.
The Federal Reserve's aggressive efforts to thaw the credit markets appear to be working, albeit excruciatingly slowly, and recent data show signs of life returning to the commercial paper market. The efforts will continue and a further cut in US interest rates can be expected by the end of the year.
Secondly, there can be no doubt that credit rating downgrades and default rates will move higher through 2009 and 2010, but investment-grade bonds are currently priced for disaster. Contrary to irrational opinion, the current environment is not a repeat of the Great Depression of the 1930s where a meltdown in the financial system caused economic collapse. The margin of safety provided by current prices already accommodates for highly improbable negative outcomes.
Furthermore, the environment ahead should favour investment-grade bonds over stocks due to the renewed focus on balance sheets and cash flow. Indeed, it is normal at this stage in the cycle for companies to curtail investment spending, shed labour, restrict dividend increases and reduce share repurchase activity. There is already evidence of such measures being taken across the corporate sector and all are bondholder friendly.
Investment-grade bonds incurred double-digit losses in a matter of weeks from September through October as they became the first victim of the forced liquidation by leveraged institutions following the collapse of Fannie Mae and Freddie Mac. The sell-off has seen prices become divorced from reality and the real returns currently on offer are paralleled only by those available during the worst of the Great Depression.
The ability to accumulate a portfolio of high-quality bonds at 5½ percentage points above treasuries is an opportunity that should not be dismissed. The time to act is now, as equity-like returns with bond-like risk will not remain on offer indefinitely.
www.sequoia.ie
