Corporate Bonds: Now's the Time


By Margaret Popper Now that the equity market is stable but stuck, bonds are beginning to look pretty exciting. Think about it. The Dow Jones industrial average can't break much above 10800, and the Nasdaq is clinging to 2100 like a shipwreck survivor to a life raft. It's a good time to be buying corporate bonds. Yields are high, and between the large amounts of equity raised during the last bull market, reduced capital spending, and cutbacks in corporate overhead, corporations are in decent fiscal shape.

With balance sheets improving, the earnings picture stabilizing, and the global economic picture solidifying over the next two quarters, corporate spreads -- the difference between what companies pay to borrow money and what the government pays on riskless Treasury bonds -- are poised to come down. Already, the spread has shrunk by almost a half of a percentage point since January. This means now's the time for investors to position themselves for a rally in corporate bonds. Simultaneously, they can lock in long-term yields hovering around 8% on high-quality credits. That certainly beats the heck out of an unreliable stock market these days.

HOLDING A GRUDGE. "It's time to get more aggressive about investing in bonds," says Kent Gasaway, senior vice-president and portfolio manager at Kansas City (Mo.)-based fund company Buffalo Funds. "We haven't had everything going in the right direction for several years."

But individual investors are still harboring a grudge against corporate bonds. For several years now the spreads between Treasury-bond yields and corporate-bond yields have stayed at tantalizing historical highs. When spreads widen like that, investors buy in the hopes that the spreads will tighten, pushing up corporate bond prices and creating significant capital gains. But, between the Asian contagion and credit fears raised by failing telecoms, corporate yield spreads haven't come down and sparked the rally in bond prices that fixed-income investors live for.

So while institutional investors have been gobbling up multibillion-dollar financings such as the one WorldCom (WCOM) brought out a few weeks ago, individual investors have continued to park their capital in cash rather than invest in the bond market at all -- let alone corporate bonds. Last year, investors drained about $30 billion from bond funds, according to AMGData. So far this year, about $22 billion has found its way back into bond funds. At the same time, money-market funds have seen a huge $200 billion inflow in 2001 -- more than double the $82 billion of new capital added last year.

STEEPER CURVE. But there's no reason to be sitting on the sidelines. For starters, the Federal Reserve is still in an easing mode -- even after its May 15 half-percentage point cut in the Federal Funds rate. The cut in the benchmark short-term rate brought the Fed's rate cuts to 2.5 percentage points so far in 2001.

Thanks to the easing cycle, the true cost of debt to issuers is still fairly low by historical standards, even though spreads over Treasuries are pretty wide. "This debt is not expensive on an aftertax basis," points out Bruce Widas, a managing director in debt-capital markets at UBS Warburg. "A BBB-rated company is paying 5% on its debt after tax for 30-year money." Not a bad deal.

And not one that will last forever. "If I were a [chief financial officer], I'd be looking at the steepening yield curve, which is telling me the economy will do better the next six to nine months, and I'd want to do my issues before the tone turns negative for the bond market," says Buffalo's Gasaway.

Many CFOs are following his advice, and as a result, the market is flooded with paper. Corporations are issuing bonds at a record pace, with about $270 billion issued so far this year, vs. $340 billion for all of 2000, which was a record in itself. "If the window is open, you have to get it when you can," says David Carter, a portfolio manager at Boston-based fund manager Gannett, Welsh & Kotler. "What's driving corporate issuance is that corporations want money, and there is no equity market to speak of."

CORPORATE REFIS. While lots of bonds are out there and that tends to push prices down in the short term, the names coming to market tend to be good credit risks. For example, as part of its $10 billion financing, WorldCom raised $4.6 billion of BBB+-rated 30-year debt with an 8.25% interest rate. That's an investment-grade credit yielding 2.65 percentage points more than the 30-year Treasury. Last week, Citigroup (C) issued $2.5 billion of AA-rated paper due in 2006, with an interest rate of 5.75%, or 1 percentage point above the relevant Treasury bond.

These and other issuers are healthy credits with strong balance sheets. "We see these issuers improving their balance sheets," says Carter. They've got more equity than debt, and their cash flow easily covers their interest payments. Even with the economic slowdown affecting corporate earnings, credit quality is stable, says Carter. A lot of the current issues aren't everaging up balance sheets. They're merely refinancing existing debt at lower rates, or locking in long-term rates that are as low as possible.

But even these yields from creditworthy names haven't been able to entice individual investors who haven't forgotten their disappointment of several years ago. Corporate spreads over Treasuries were wide back in 1998 when the Asian crisis kicked off a brief period of Fed easing in order to stave off economic disaster.

JILTED INVESTORS. Retail investors piled into the bond market in hopes that a bond rally was imminent. "They never got what they hoped for," says Milton Ezrati, senior economist and strategist at Jersey City (N.J.)-fund manager Lord, Abbett & Co. After a brief easing to contain the Asian contagion, the Fed began a tightening cycle that lasted for 18 months, and credit problems among telecoms companies forced corporate spreads skyward.

But many of the factors that denied investors their spread-tightening rally in corporate bonds are gone. The Fed is easing. Aside from investment-grade names like WorldCom, the telecoms sector isn't issuing debt. "We've seen the worst of the telecom problems," says Ezrati. "I don't think it will get worse. But the current spreads on corporate bonds anticipate a dire situation."

Given that spreads are reflecting a desperate reality that doesn't exist, they're bound to come down. When they do, investors who bought into the current spate of high-yielding corporate bond issues from creditworthy issuers are going to feel really smart. Popper covers the markets for BW Online in our daily Street Wise column


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