The Motley Fool - December 11, 2007
Difficult economic fundamentals for the U.S. corporate bond market are likely to persist at the start of 2008 and could send adventurous fixed-income investors far afield in places like Brazil and Russia to capture enticingly high yields.
When the new year begins, investors could still be confused about whether a U.S. recession is at hand. And this confusion should make them wary about putting their money in domestic corporate bonds as a recession would lower earnings prospects. The corporate bond market tracks earnings as carefully as the stock market does because bond values are tied to balance sheets.
"The overriding issue is whether the Federal Reserve became involved quickly enough to avoid a recession," said Joe Balestrino, fixed-income market strategist at Federated Investors Inc., referring to the central bank's decision to impose rate cuts this year. The Federal Reserve lowered a key interest rate by one-quarter of a percentage point Tuesday, the third cut in the past three months.
"If you think that the Fed has acted quickly enough, you can go into the corporate bond market," he said. "If you think they have not, you must stay out."
As a rule, bond investors try to gain the highest possible yield potential with the lowest possible risk element. But because it currently is difficult to gauge the risk level in the economy, many investors will probably avoid the domestic corporate sector.
Given that state of affairs, some investors are seeking the higher yields that can be found in emerging market countries at a time when the risk level is declining as fundamentals improve in many of these economies.
"The countries we are interested in include Brazil, Russia and Mexico," said Ed Vaimberg, sector manager of emerging markets at Hartford Investment Management. "These countries have been very important to the emerging markets field, and there are many opportunities there in corporate bonds, in our viewpoint."
Within those countries, Hartford Investment Management is interested in sectors such as mining and steel which support the vast construction projects underway throughout the developing world. The firm focuses on companies that have the potential to evolve into global leaders, which tend to be larger firms, according to Nasri Toutoungi, a senior portfolio manager at Hartford Investment Management.
In addition, bonds of emerging market governments issued in local currency could perform well in 2008. For instance, in Brazil government bonds issued in the national currency, the real, often yield as much as 13 percent, while dollar-denominated bonds generally yield no more than 7 percent.
Investors leery of the U.S. corporate market's murky prospects also can turn to the European market for high-yield debt, once known as junk bonds, according to Jim Sarni, managing principal of bond firm Payden & Rygel.
High-yield bonds do not carry the security of investment grade ratings, but they do offer higher yields. Bond default rates remain low in Europe, meaning buyers can get better return on their investments there without running a high risk of default.
However, Federated's Balestrino believes the U.S. high-yield market deserves some attention too, particularly if the economy avoids a recession. The recent crisis of confidence in the bond market due to subprime mortgage problems sparked numerous selloffs that have left many assets attractively cheap, he said.
"There is very good upside potential if we don't go into a recession," he said. "We have had a brutal marketplace in late 2007, and now just about everything is cheaper." However, he cautions that buyers should avoid bonds issued by financial and housing sector companies, as these challenged groups are not likely to rebound quickly.
Buyers who want to avoid U.S. corporate debt, but aren't comfortable investing internationally could consider the municipal bond market.
The muni sector also underwent turmoil in 2007 amid concerns that rising defaults on subprime mortgages would strain the finances of bond insurers. Heavy selling sent yields on municipal bonds higher, but Payden & Rygel's Sarni said many city and county governments will not be exposed to the troubles of bond insurers. He believes this indicates munis have been punished too severely and spells an attractive opportunity.
