A Better Deal in Corporate Bonds

Investors in corporate bonds haven’t gotten much for their money lately, but new signals suggest that’s all about to change.

After a nearly 12-months tear, companies have been issuing fewer bonds — a sign bond investors are tired of settling for low yields and weak investor protections, say market watchers. In June, issuance of new high yield bonds dropped 68% globally and 66% in the U.S. — a turnaround from May, when global issuance hit an all-time monthly record of $50 billion, according to Thomson Reuters.

Investment-grade bond issuance was down, too — 46% globally and 65% domestically. Ultimately, this could show investors are demanding better deals before snapping up new issues again, says George Young, portfolio manager of the $85 million Villere Balanced fund (VILLX). “You have sort of a standoff right now where investors say that’s not enough of an incentive for me to lend you money.”

In fact, this is already playing out in some parts of the market. Yields on corporate bonds both investment grade and high yield — have inched up over the last few months as investors deemed them riskier investments and started demanding better rates, says Andrew Catalan, managing director of investment grade strategies for Standish. High-yield bonds now pay 5.3 percentage points more than comparable Treasurys, up from a low of 4.6 percentage points in April, according to Standard & Poor’s Equity Research. Investment-grade bonds pay 1.7 percentage points over Treasurys, compared to a low of 1.6 percentage points. For investors, the higher yields mean corporate bonds are beginning to become attractive again, says Young.

The reversal in issuance was bound to take place sooner or later, say experts. Rabid appetite for corporate bonds over the last year has pushed prices up and yields down until investors simply bailed out, says Young. Plus, a host of economic worries — including the spreading debt crisis in Europe, the still-weak housing and job markets in the U.S. and concerns about how the U.S. will handle its debt-reduction plan — have driven investors away from corporate bonds and to safer bond investments and cash. Meanwhile, the combination of slack demand and a riskier economic environment has discouraged companies from issuing new bonds, says Jeff Tjornehoj, a senior analyst with fund researcher Lipper.

But while the corporate bond market may be shifting in favor of investors, experts caution there are still good reasons to steer clear until conditions improve more. Bond and equity performance could remain volatile until a resolution for dealing with the debt crisis is achieved in Europe and at home, and until economic reports on housing and unemployment brighten, says John Lonski, a chief economist at Moody’s Investors Service.

For example, Lon Erickson, corporate bond fund manager for Thornburg Investment Management, increased his fund’s cash holdings to 5% from about 2% last month and says he would like to see yields increase by another .25 to .5 percentage points before putting more of his money to work in corporate bonds. “There’s definitely more noise and volatility and you want to be compensated for that,” says Erickson.

In the meantime, investing pros recommend sticking to only higher-quality corporate bonds and reducing exposure to junk, says Lonski. Fund manager Young says investors should also consider high-quality dividend paying stocks, which provide stable payments but could also rise if the economy improves, says Young. “I would approach the current situation with a great deal of caution,” says Lonski. “This may not necessarily be the best time to increase your exposure to risk.”