| Corporate bondholders may soon be demanding bigger rewards for their risks.
Over the past three months, inflation fears have caused the yield on the 10-year Treasury note to rise nearly 50 basis points to the 5.1% neighborhood from 4.6%. As a result, the spread between economically sensitive high-yield bonds and Treasuries widened to 300 basis points from 250.
But while junk-bond spreads mirrored the move in Treasuries, investment-grade bond spreads nudged higher by only 10 basis points, to 90 from around 80. And in the eyes -- and pockets -- of many investors, that's not enough of a cushion, considering the risks lurking in the credit markets.
"Corporate fundamentals are generally solid, but investors are not getting paid enough for the event risk out there," says Matthew Hastings, co-manager of the $13.5 billion Schwab YieldPlus Fund. "For example, Home Depot (HD - Cramer's Take - Stockpickr - Rating) announced a big stock buyback, but they are funding it via debt and asset sales. Eventually that additional leverage will cause the ratings to fall."
Hastings' fund, which sports a five-star rating from fund tracker Morningstar, is up 2.5% this year and yields 5.26%. The fund holds close to 45% of its assets in investment-grade corporate bonds. Standard & Poor's classifies investment-grade bonds as BBB or higher, and Moody's classifies investment-grade bonds as Baa or higher.
In addition, Hastings says corporate bond owners are not being appropriately compensated for the barrage of new supply that's hitting the market because of the many private-equity-leveraged buyouts.
"The wave of new issues due to LBOs is filtering into higher-quality bonds, and it's creating a fairly dangerous situation for investors," says Hastings.
Despite the increase in event risk, Hastings says it's important to remember that the economy is still performing quite well, so credit spreads should not be blown out of proportion.
"A company like Home Depot will not default on its debts," says Hastings. "Default rates are still historically low, so large-cap companies will surely be able to withstand a turndown in the economy."
Hastings is also relatively unconcerned about the so-called "subprime slime" contaminating his fund. A third of YieldPlus is invested in high-quality mortgage-backed bonds, which Hastings insists are safe from the inferior mortgage bonds that are currently freaking out the coupon-clipping world.
"High-quality CMOs [collateralized mortgaged obligations] may take a small hit if they are marked to market during a downturn, but you will get your money back because they are insured by Fannie Mae (FNM - Cramer's Take - Stockpickr - Rating) and Freddie Mac (FRE - Cramer's Take - Stockpickr - Rating)," says Hastings. "That's not like subprime debt where you might not get your principal back."
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