Big Values Beckon in Corporate & MBS Bonds

After witnessing a major rally following the Bear Stearns Cos. bailout in mid-March, investment grade corporate credit spreads have risen to multi-decade highs this summer.
Long-term value investors should consider nibbling at these levels because interest rates for many bonds in the non-financial sector now pay attractive inflation adjusted yields.

But I’d avoid most financial company debt instruments because these securities will remain distressed much longer amid ongoing balance sheet erosion and high risk premiums to fund borrowing obligations.

The corporate debt market now yields an effective 3.11% above risk-free Treasury bonds compared to 3.05% at their pre-Bear Stearns’ peak in March, according to Merrill Lynch.

The Dow Jones Corporate Bond Index now yields an effective rate of 6.04% or a 2.20% above ten year Treasury bonds. That’s also at a multi-year high.

One of the cheapest ways to invest in investment-grade corporate debt is to buy low-cost exchange traded funds (ETFs). These products are listed in the United States and offer daily liquidity. You can also find similar products traded in Frankfurt, Germany and denominated in euro (

Another segment of the credit markets also offering high value is the mortgage-backed securities market or the MBS sector.

PIMCO’s CEO Bill Gross, widely regarded as the dean of bond investing, continues to increase his holdings of mortgage-backed securities at the expense of Treasury bonds. Gross’s flagship PIMCO Total Return Fund ($130 billion in assets) increased its holdings mortgage bond holdings in July to 65% from 61% in June. Gross has been slicing his Fund’s exposure to Treasury bonds all year claiming these securities provide poor inflation adjusted values.

The investment grade corporate debt market and mortgage-backed securities are cheap. These products provide a low correlation to common stocks while also paying attractive inflation adjusted yields. Plus, non-financial corporate bonds offer strong balance sheet management since most issuers have healthy cash flows and have reduced net debt this decade, unlike the financials, the federal government, states and municipalities.

In fact, I prefer to own the corporate debt of, say, Coca-Cola or Exxon-Mobil Co. than the U.S. federal government or the state of California. These and other S&P 500 Index non-financial companies have far healthier balance sheets.

As the U.S. and global economy continues to slow this year, inflationary pressures should also cool. This should open the door to higher bond prices, especially in the high grade investment sector and mortgage-backed securities. But I would still avoid junk bonds or high yield debt because the corporate default rate for risky issuers continues to rise and won’t peak over the next 12-18 months.

Have a good weekend. See you on Monday.

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