A Case For Being Selective With Corporate Bonds

OCEAN CITY -- Traditionally, investors seeking calm waters have looked to sovereign debt in developed economies. This would explain, for example, the heightened demand for U.S. Treasuries in recent years. Today, however, many large multinational companies — though certainly not all — increasingly look like a better refuge for capital than many countries do. The shift stems partly from a new era of corporate conservatism that, in the wake of the economic crisis of 2008, prompted corporations to shore up their balance sheets, pay down debt and build cash reserves. For example, even corporate issuers of high-yield bonds now hold $2 of cash for every $1 of short-term debt, on average, according to Oleg Melentyev, a high-yield emerging market credit strategist for BofA Merrill Lynch Global Research.

At the same time, concern continues to mount over the precarious position of highly indebted euro-zone countries and the potential for contagion rippling across the Atlantic to the U.S., which has already suffered a debt-rating downgrade by Standard & Poor's. "It's easy to see how the situation could continue to spiral," Melentyev says. That has made corporate bonds increasingly attractive for investors seeking quality and yield — provided that they take care to be selective. "In terms of debt instruments out there right now," Melentyev says, "the corporate landscape is an island of relative stability."

Overall, many companies appear to be in good shape in terms of their relatively low probability of defaulting on debt and their ability to generate profits sufficient to cover their interest expenses.

 "Leverage has come down, and with the Federal Reserve maintaining lower rates, interest expenses are lower as well," Melentyev explains. "Some issuers have benefited directly from lower rates, while others refinanced fixed debt to bring down their interest payments."

Although flagging confidence in the economy has fueled some speculation about a double-dip recession, even that would be unlikely to significantly derail corporate issues, Melentyev observes.

"During the years immediately following a recession, companies are cautious — no one wants to hire, borrow or invest,” he said. “We have yet to see a return to more confident, aggressive behavior. So even if we go into a double dip, we're unlikely to see cyclically high default rates. That would require a more normal debt load on balance sheets, which we don't have today."

Despite this fairly benign default outlook, U.S Treasuries and cash remain the prime refuge for the risk-averse. But with five-year Treasuries yielding just less than 1% and interest on cash investments negligible and likely to remain so for the foreseeable future, investors could pay dearly for the safety those vehicles provide.

By comparison, investment-grade bonds — low-risk debt issued by companies enjoying a Standard and Poor's rating of "BBB" or higher — are currently yielding 4.8%, and U.S. high yields — the higher-risk debt of companies with an S&P rating lower than BBB — are at approximately 8.9%.

"The high-yield market is susceptible to a higher risk of default than the investment grade market, and there will be defaults," Melentyev cautions. "But in a diversified portfolio that contains high-yield bonds, you can still come out ahead."

While aiming for long-term performance, corporate bond investors should guard against the risk of inflation and climbing interest rates. Inflation has been steadily ticking upward, recently hitting its highest point since September of 2008. And though the Fed has pledged to keep interest rates near zero through mid-2013, interest rates will eventually begin to rise. Corporate bond investors concerned about principal erosion in an environment of higher interest rates should consider holding bonds with shorter maturities. As always, however, it's crucial to be selective when you're contemplating corporate bonds.