Where the Credit Freeze Has Thawed

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Risk Priced In

On Oct. 7, credit spreads on the bonds of speculative-grade companies were 10.55% above Treasury notes, signaling the elevated level of risk being priced into this debt. "Companies are choking if they have to come to market, because [of the] margin above Treasury yields," says Vazza.

Spreads for investment-grade bonds were 3.7% higher than comparable Treasury notes on Oct. 7, which Vazza called "rather extraordinary."

The investment-grade bonds of entire sectors have been unfairly punished due to the general lack of liquidity as a result of spillover from the financial industry. In the energy sector, exploration and production companies like Chesapeake Energy (CHK) and integrated oil producers are relatively safe bets despite sharply lower oil prices since they are still generating heaps of free cash flow and have very little debt on their balance sheets, says Labrinos. The recent widening of their credit spreads to dramatic levels, however, has given investors reason to wonder about how safe they are, however.

Driven by Investor Demand

Demand for the bonds of metals and mining companies has also retreated lately as stocks such as Freeport McMoRan Copper & Gold (FCX) have taken a beating. But bondholders of both investment-grade and high-yield issues have less reason to be worried as these companies continue to amass cash, have adequate liquidity and very little debt, he says. Labrimos also recommends the high-yield bonds of regional communications companies like Frontier Communications (FTR) and wireless companies such as Sprint Nextel (S), which haven't loaded up on debt and have more conservative business models than they once did. He views aerospace and defense companies as less risky by virtue of not being having much exposure to the business cycle.

"A few months ago, we thought high-yield bonds were too expensive," he says. "Now we see lots of value out there," but investors need to distinguish between sectors and do their homework.

Most of the corporate debt deals are being driven by investor demand rather than just companies' need for capital, says Jim Keegan, portfolio manager of the Ridge Worth Intermediate Bond Fund (SAMIX). Union Pacific's (UNP) offering of $750 million worth of 10-year bonds was one of just three deals priced last week. It came to market as a was a reverse inquiry, where the term and nominal yield—a 7.875% coupon—were suggested by investors through a dealer and accepted by the company. "It's the old saying 'You borrow when you can, not when you have to,' and that's been clearly on display the last few months," says Keegan. "The railroads are a capital-intensive industry. It's always better when you're borrowing money that there's demand for that type of credit."

Investors Are Spooked

Keegan says his focus has been on high-quality defensive names in the consumer staples, utilities and pipelines industries that have healthy levels of free cash flow and little need to refinance debt in the next 18 months.

While most bond investors are too spooked by the mounting body count in the financial industry to retain much of a stomach for high-yield corporate bonds, Labrinos sees their record-high yields as a sign of good value in general, but advises investors to be selective by sector. Spreads of 14% above comparable Treasury yields are implying defaults that are much higher than anything seen thus far, he says.

Cabot's Larkin likes the bonds of AT&T (T), Verizon Communications (VZ), and CVS Caremark (CVS) as defensive plays. General Mills (GIS), Kimberly-Clark (KMB), and Anheuser-Busch (BUD) are of such high quality that their bonds are prohibitively expensive right now, he says.

Protection Against Credit Risk

More affordable, he says, are some older Anheuser-Busch bonds he bought on the market recently that have a 9% coupon and mature at the end of 2009. One key attraction was a feature that's been missing from corporate issues for the past 10 years: credit-rate-sensitive puts. Those puts allow the holder to put the bond back to the issuer for full redemption if the bonds fall below investment grade, That type of added protection will definitely make a comeback as companies try to be more competitive in order to attract investors, he predicts.

"Everybody thinks the capital markets are broken. I just think the capital markets were too cheap," he says. "[Deals] will get done, but they will just get done at the right conditions. The market has to adapt and the problem is adapting can be difficult."

Bogoslaw is a reporter for BusinessWeek's Investing channel.