Bonds that beat stocks, hands down

By Tim Middleton

For months, investors have been debating whether we are entering a period like the 1930s: hard times and high risks, but big rewards down the road for those who can take advantage.

In the world of corporate bonds, we are already there.

"The levels of default the market is pricing in (in investment-grade corporate bonds) haven't been seen since the Great Depression," says Todd Burchett, a member of the investment committee at Icon Advisers in Denver.

In short, this slice of the bond market is priced low, as if dozens of companies won't be able to make good on their debts, presumably because they'll go broke.

But you can find these low prices even on the gilt-edged bonds of rock-solid corporations such as General Electric (GE, news, msgs), Berkshire Hathaway (BRK.A, news, msgs) and Johnson & Johnson (JNJ, news, msgs). They're yielding nearly 5 percentage points more than Treasury bonds of comparable maturity; 2 to 3 points would be normal. You won't see those kind of returns again for a very long time -- and perhaps never again.

"The corporate marketplace is pricing in default rates several percentage points higher than we've seen in our lifetime or even the lifetime of the bond market," says Elaine Stokes, a co-manager of Loomis Sayles Bond Fund (LSBRX). "This is absolutely a buying opportunity."

The reasons are partly technical, but the bottom line is that this asset class is perhaps the most compelling investment opportunity in today's marketplace. I expect equitylike returns, well into double digits, over the next year or two. And everyday investors can easily target these bonds with mutual funds and exchange-traded funds.

"You want to look at corporate bonds," says Brian McMahon, the chief investment officer of Thornburg Investment Management and a co-manager of Thornburg Investment Income Builder Fund A (TIBAX). "You have yields on (investment-grade) bonds just below 9%, and those yields look pretty good right now."

I have a feeling a lot of us will be happy earning 9% over the next couple of years.

Prices tumble on fright

October is often a terrible time for equities, and October 2008 was the worst since 1987. The price of one of the purest ways to play corporate bonds, iShares iBoxx $ Investment Grade Corporate Bond (LQD, news, msgs), an exchange-traded fund, tumbled 12.9%. Stocks went down, too, but only about a quarter more. That left bonds looking more attractive because they're much, much more secure.

One big reason: If a company does go broke, bondholders get paid before stockholders.

And the truth is that even in this lagging economy, major U.S. companies are not about to go bankrupt en masse. "Corporations are much more levered outside the United States than inside the United States," McMahon notes.

In Europe, the debt-to-equity ratio averages 75%; in Japan, it's more than 90%. In the U.S., it's only 40%. "The aggregate corporate balance sheet is in pretty decent shape" in this country, McMahon says.

But despite this, prices on investment-grade bonds have been driven to historic lows, partly because of massive redemptions at hedge funds, which ran short on liquid assets and had to sell the corporate bonds they owned to repay investors wanting their money back.

Think of bond prices and yields as the opposite ends of a teeter-totter. Yields go up when prices go down, to the same degree. Bonds issued at 6% don't trade at face value when competing yields are 9%; their price goes down enough for the yields to rise to 9%. That's what has happened to corporate bonds.

Right now, you can buy more yield for less money. So investors stand to reap capital gains as well as dividends when prices head back up.

Continued: That could happen soon

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.