Playing for Growth in Corporate Bonds

By RICHARD BARLEY Will rising government-bond yields upset the slam-dunk trade of the year: investment-grade corporate bonds? After all, 10-year Treasury yields hit 4% this week, from just over 2% earlier this year. The risks have risen, but company debt still looks attractive. The relationship between corporate- and government-bond yields isn't straightforward. The drivers of corporate-bond performance tend to be default rates, economic growth and shocks to risk appetite. Since 1970, corporate-bond-yield spreads have actually tended to widen more often when government-bond yields fall than when they rise, according to Dresdner Kleinwort. The key is to understand why government-bond yields are rising. If investors believe in an economic recovery and have more risk appetite, that is good for corporate bonds, as creditworthiness should recover along with profits. If it is because inflation expectations are rising, that is usually negative for fixed-income investments. But even though there is a risk that ultraloose monetary policy helps stoke inflation longer term, it looks under control for now. Meanwhile, if rising government-bond yields reflect concerns about the huge amount of paper needed to fund record deficits, that would be negative for corporate bonds. Companies could find themselves forced to pay higher yields to lure investors back. For institutional investors, government-bond yields remain some way below levels that would cause big allocation shifts; BNP Paribas estimates these triggers lie between 4.5% and 7.5%. The bigger risk: individual investors, a source of demand for corporate bonds this year, get spooked, and the tide of money coming into the market slows or reverses. At this point, there is no reason why they should. Government yields still are relatively low by historical standards. Meanwhile, U.S. corporate-bond yields of 6%-7% look relatively attractive in a low-interest-rate world. And spreads still are wide, meaning investors have a generous cushion to absorb losses. Now stocks have run up so quickly, corporate bonds are a lower-risk way to bet on continued healing in the economy. Write to Richard Barley at richard.barley@dowjones.com