Corporate Bonds in Favor

By ANNELENA LOBB and ROB COPELAND While the stock-market rally is hogging the headlines, corporate bonds are staging their own remarkable surge. The average junk-rated company is now no longer "distressed," meaning yields have fallen to less than 10 percentage points above the benchmark Treasury bond. Yields on higher-quality companies also are dramatically lower as investors feel less leery about corporate debt. As yields fall, bond prices rise. Stocks and corporate bonds are benefiting from the same generally upbeat mood this earnings season on signs in quarterly reports the economy is winding toward the end of the recession. Still, it is hard to blame investors for not plowing all their cash into stocks. Some investors are choosing to hedge their bets, preferring corporate bonds over stocks. They say even risky bonds are a smart cushion against uncertainty about the stock-market rally's staying power. "If you believe in a V-shaped recovery, then you buy stocks. If you believe we're going to bump along, then you have to go with credit," says Kent Wosepka, chief investment officer of active fixed income at the Standish Mellon Asset Management Co. unit of Bank of New York Mellon Corp. "If I told you that you could get 10%-plus in equities, you would jump at it." Even if the default rate on high-yield corporate bonds hits the 14% rate by the end of 2009 projected by analysts at Citigroup, returns from the junk that survives would more than offset the default-related losses, says Mr. Wosepka, who oversees $186 billion in assets. In addition, bondholders typically get some money back following a default. Stock investors usually are wiped out when a company files for bankruptcy protection. Since early March, the Standard & Poor's 500-stock index has rocketed 45% higher, while the Dow Jones Industrial Average is up 39%. The Dow rose 4% last week, and the S&P 500 gained 4.1%. Meanwhile, the spread between investment-grade bond yields and Treasurys has been halved to about three percentage points, according to Merrill Lynch. High-yield spreads are down sharply from their all-time high of 21.8 percentage points in December. Total yields on junk bonds average about 12.3%, above their 10-year average of 10.7%, Merrill calculates. Returns on high-yield bonds could reach the midteens over the next year, as long as the recession doesn't deepen, the recovery is sluggish and Treasury bond yields don't change much, says Martin Fridson, chief executive of Fridson Investment Advisors. Other investors still think stocks will outperform bonds as layoffs and other cost-cutting moves position companies for an earnings rebound. Last week, Goldman Sachs analysts predicted the S&P 500 would hit 1060 by year end, up 8.2% from Friday's close. Some bears are steering clear of corporate bonds and stocks for now. "People buying into the stock market are buying into hope," says Thomas Mangan, a portfolio manager at the James Balanced: Golden Rainbow Fund. Mr. Mangan recently bought Treasurys, since he believes the U.S. economy may fall into a deeper recession. Corporates "are not a place to go as a safe haven," adds Mr. Mangan. His fund manages about $540 million. But Michael Kaminsky, a portfolio manager at Neuberger Berman LLC, says economic uncertainty makes bonds from low-rated companies with strong balance sheets and cash flows look more attractive than their stocks over the next three years. "You can still make 8% to 12% in noninvestment-grade credits today," he says. He bought investment-grade bonds when they notched similarly high returns late last year, though now favors dividend-paying large-company stocks. Among below-investment-grade companies, Mr. Kaminsky holds the stock and debt of cellular-tower company American Tower and energy companies Enterprise Product Partners and Regency Energy Partners. He also owns Terex bonds, but not the industrial company's stock. Those holdings are in one of the two investment strategies Mr. Kaminsky co-manages for Neuberger, worth about $4 billion. It now holds about 45% stocks, 40% bonds and 15% cash, compared with 80% stocks and 20% cash a year ago. Junk-bond issuers must pay higher rates to investors, because ratings agencies consider them more likely to miss payments or default than investment-grade bond issuers. "I'm looking for stock-market-like returns without all the risk of stocks," says Keith Springer, president of Capital Financial Advisory Services. The Sacramento, Calif., firm manages about $80 million, about half of which is in corporate bonds, 30% in dividend-paying stocks and 20% in cash. He recently bought triple-C-rated GMAC bonds that offer about 12% a year for three years, and one-year Sallie Mae bonds with a 9.25% yield to maturity. "Maybe the companies don't make money, but I don't care. You just need a company to stay in business to pay the bonds, even if the stocks don't rally," he says. Write to Annelena Lobb at annelena.lobb@wsj.com