Spread your bets


The credit crisis of the last 12 months has changed the landscape for bond investors, who now receive extra compensation for taking on credit risk.

Spreads between the yields of various bond classes and Treasury bills have expanded to historically high levels. Currently, long-term, high-quality (AAA-rated) corporate bonds yield 3.8% above the yield of three-month Treasury bills — well above the average spread of 2.8% over the last 10 years.

Most other types of bonds have seen similar changes:

Yields on Baa-rated bonds, the low end of investment grade, are approximately 5% higher than T-bill yields, well above the 10-year average spread of 3.7%. Ten-year Treasury notes yield nearly 2.2% above T-bills, versus a 10-year average of 1.4%. Municipal-bond spreads have more than doubled in recent months, while the current spread between high-yield corporate bonds and T-bills is 7.3%, the highest in more than four years.

Not only are spreads wide, but absolute yields for both investment-grade and high-yield corporate bonds are at or above the average levels since 2004. High-yield bonds now yield more than 9%, well above the 6.6% yield at the end of 2004.

Wide spreads between low-risk Treasurys and riskier bonds tell us the market is paying investors more for taking on risk, but not necessarily that bonds are good investments.

So, do current spreads represent an attractive opportunity for yield-hungry investors? To answer that, we must consider why the spreads are so high.

The most important factor affecting spreads on corporate bonds is the risk of default. At the end of 2007, default rates on junk bonds (also called high-yield bonds) were approximately 1%. But credit quality, as measured by ratings downgrades, has deteriorated significantly over the last five quarters. In the first quarter of 2008, Moody’s Investors Service downgraded nearly three times as many bonds as it upgraded, versus a ratio of nearly 2-to-1 in the fourth quarter of 2007.

Declining corporate profits in some sectors, as well as balance sheets bloated with debt in the wake of the private-equity and merger mania of 2007, have increased default risk. Moody’s expects the default rate on junk bonds to jump to 4% by the end of 2008.

Yet, while high-yield spreads have risen to recessionary levels, a case can be made that the Dow Theory’s bull-market signal in April portends a stronger economy and improved corporate profits later this year — developments that should reduce default pressures.

Another risk to consider is inflation risk. The fact that the yield spread between 10-year Treasury notes and 3-month T-bills is above historical norms implies investors expect higher inflation.

The Forecasts continues to believe that stocks remain the most attractive asset class for total returns over the next 12 months. Still, we realize that most investors should own some fixed-income for diversification purposes. Such investors should take advantage of the historically high yield spreads and spread their bets across a mixture of bond classes.

Among high-yield bond funds, the Forecasts favors the Vanguard High-Yield Corporate ($6; VWEHX) and the USAA High-Yield Opportunities ($8; USHYX) funds. For investors who prefer exchange-traded funds, the SPDR Lehman High Yield Bond ($45; JNK) and iShares iBoxx $ High Yield Corporate ($97; HYG) have appeal.

For long-term corporate bonds, consider the Vanguard Long-Term Bond ($74; BLV) and the iShares iBoxx $ Investment Grade Corporate Bond ($102; LQD) exchange-traded funds.

Finally, for long-term Treasurys, consider the iShares Lehman 10-20 Year Treasury ($103; TLH) exchange-traded fund.

Also, investors with taxable accounts should consider quality tax-exempt funds, such as the Vanguard Intermediate-Term Tax-Exempt ($13; VWITX) mutual fund and the iShares S&P National Municipal ($101; MUB) and SPDR Lehman Municipal ($22; TFI) exchange-traded funds.

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