Bonds that beat stocks, hands down

That could happen soon

Meanwhile, there are signs the credit crunch is beginning to ease. On Oct. 10, Libor -- the London Interbank Offered Rate, a measure of the interest banks charge each other for overnight loans -- soared to a premium above Treasury bill yields of 4.63 percentage points, one of the highest rates in history. Last week, it dropped to 1.74 points. While still far above its historic average of 0.40 above Treasurys, it reflects an ease in borrowing and confirms a growing willingness of banks to lend.

The past has been a preview of the future on Libor before. In summer 2007, the spread over Treasurys spiked from 0.48 to 2.40 percentage points in just two weeks. At the time, the S&P 500 Index ($INX) was around 1,400, about 64% higher than its close Nov. 12. Just as the spike presaged a market collapse, an easing in credit markets rates could foreshadow a stronger market for stocks.

It also means higher prices for bonds.

In a letter to investors this month, Icon Advisers stated: "Over the next year, we will be looking for corporate bonds to rally. We believe that a bond rally must be under way before stocks begin any sustainable move."

Buy for a rally

Corporate bonds account for roughly one-third the weighting of the Lehman US Aggregate Bond Index, and pulled it down more than 3% in October, its worst month since February of 1980, when interest rates were topping 16%. So any intermediate-term bond fund -- the largest is Pimco Total Return (PTTRX) -- is a buy in today's market.

But specialized vehicles that invest strictly in corporates, such as the iShares ETF, are likely to provide the most bang for the buck. Multisector bond funds, such as Loomis Sayles and T. Rowe Price Spectrum Income (RPSIX), are also good candidates.

High-yield corporate bonds, or junk bonds, are even more depressed than gilt-edged debt, and in that marketplace defaults really are rising and conditions are apt to get worse before they get better. Beware of these. "One thing pressuring high yield is the bank loan market," Loomis Sayles' Stokes notes. "We are continuing to see a lot of (broken deals), and since bank loans are typically senior to high-yield paper, high-yield issuers get pushed down. We are definitely seeing some continued pressure there."

Aggressive investors tend to avoid bonds altogether, because bonds are often viewed as safe but underperforming. But this is a different investing world.

I have a relatively modest bond portfolio. But I boosted it early in November after I alerted the readers of my newsletter, ETF Insider, to this opportunity and recommended they increase their exposure.

Best case, I can see high-quality corporate bonds surging 15% on price alone as their premium over Treasurys falls back toward the historic norm, with dividends chipping in 6% to 9% over the next 12 to 18 months. Few stocks can deliver returns like that, especially in this market.

At the time of publication, Tim Middleton owned the following funds mentioned in this article: iShares iBoxx $ Investment Grade Corporate Bond and T. Rowe Price Spectrum Income.

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