April 2009

In a year that was painfully out of the ordinary, at least one type of investment kept to the historical script.

“Treasury securities actually posted solid gains in 2008 despite the dismal economic climate,” says Susan Czochara, senior product manager for Northern Trust Global Investments. “But that often happens during a severe recession.”

In fact, long-term government bonds returned about 5% a year during the Great Depression.

But while most government securities did well, corporate bonds lost altitude.

Lots of altitude.

During the credit crunch last fall, investment-grade bonds dropped by more than 10% while some high-yield debt tumbled by almost 40%. Considering the relative calm that usually characterizes much of the domestic bond market, those are startling numbers.

Bargain hunting
But that‘s old news. Financial markets look to the future, and investors are wondering if last year‘s precipitous drop in non-Treasury bond prices might represent a buying opportunity of historic proportions.

Perhaps, says Colin Robertson, senior vice president and managing director of fixed income for Northern Trust. But Robertson also cautions that investors need to choose wisely.

“Treasuries already have had a good run,” he says. “There are other areas of the bond market that haven‘t performed as well and may now offer good value.”

Not that the party in Treasuries is necessarily over just yet.

The Federal Reserve‘s decision in March 2009 to begin “quantitative easing,” a process that involves the direct purchase of government debt, is an important development. This policy shift could delay a rise in Treasury yields from unusually low levels while boosting the price of other government-guaranteed securities, especially mortgages.

“The Fed wants to lower mortgage interest rates to stimulate the housing sector,” Robertson says. “We think government-guaranteed mortgage securities offer a favorable balance of risk and reward.” Government-backed agency debt also looks attractive, he says.

Longer term, however, Robertson predicts that an economic recovery, coupled with mounting Federal budget deficits, will push Treasury yields higher, which is why he‘s starting to add — slowly and carefully — selected names in the hard-hit corporate sector.

Preparing for stage two
The relative performance of the fixed-income market during a typical economic cycle can be divided into three stages.

Government bonds usually perform best when investors see an economic downturn on the horizon. Market leadership then shifts to agency, mortgages, and higher-quality corporate bonds as the economy stabilizes. Finally, sub-investment grade (high-yield) debt usually outperforms when an economic recovery seems certain.

Robertson thinks the current economic cycle is anything but typical.

Still, Treasuries did well in 2007 and 2008 as the full extent of the credit crisis and global recession became known. More recently, some investors have started to exit Treasuries in search of more generous yields. Higher-quality investment-grade bonds have attracted the strongest buying interest while the high-yield sector has stabilized. At the moment, the flow out of Treasuries is only a trickle, but that could change as the economy heals.

“The challenge is in knowing when to shift money out of government bonds and into corporates,” says Robertson, who acknowledges that the economy is mired in a deep recession that shows no sign of ending soon. “Corporate credit will bottom long before everything is rosy again,” he says. “By the time the outlook is favorable, it will be too late to get the best prices and yields.”

Generous yields
The investment-grade sector comprises bonds rated from Aaa to Baa by Moody‘s, and from AAA to BBB by Standard & Poor‘s. It‘s within this medium- and high-quality group that Robertson has been finding the best opportunities.

“It‘s important to be selective, but yields on some sound credits reflect default expectations that are excessive, based on our analysis of today‘s risks and historical experience.”

Excessive, indeed.

As of mid-March, Aaa-rated corporate bonds yielded 2.5 percentage points more than Treasuries, or more than twice the average spread between 1976 and 2008.

The 5.47% yield available on Aaa corporates seems especially generous given that no Aaa-rated security has defaulted in more than a quarter century.

Things are even more interesting in the lower-rated regions of the investment-grade market.

Since the mid-1970s, the Baa corporates have yielded an average of 2.09 percentage points more than 10-year Treasury bonds. But that number recently spiked to 5.52 percentage points as investors fretted over the ability of companies to meet their obligations in a souring economy.

Those concerns aren‘t misplaced, Robertson says, but they might be overdone.

“We think it‘s too early to move aggressively into the sub-investment grade sector,” he says, referring to bonds rated BB and below. “But to be able to get an 8%-plus yield on an investment grade corporate bond in a healthy sector represents an infrequent and attractive opportunity.”

The historical record also suggests that credit worries may be misplaced, at least when it comes to investment-grade corporate bonds. Since the 1930s, the group‘s default rate has never exceeded 1%, according to Moody‘s.

It‘s a very different story in the high-yield sector, however, where defaults reached 5% in February 2009 and are expected to peak at about 15% late this year. During the last two recessions, high-yield default rates topped out at 10.4% and 11.1%, and have averaged 4.29% during the last 30 years.

Though many sub-investment grade bonds now yield close to 17%, Robertson still isn‘t jumping into high yield with both feet.

“Markets often overshoot, and I don‘t want to place too large a bet on lower-rated credits in case that happened,” he says. “We‘re positioned relatively defensively. That‘s generally how we manage our discretionary fixed-income portfolios, and it‘s been effective.”

Multifaceted approach
Besides gauging the impact of the recession and economic recovery on the various sectors of the bond market, there are other challenges as well.

Credit ratings often change — downgrades have become commonplace in recent months — and the rating agencies themselves are sometimes wrong about an issuer. That’s where the professional management available through a bond mutual fund can help.

“We do our own credit research,” Robertson asserts. “The ratings assigned by the three credit agencies are just a starting point.”

In fact, Northern’s fixed-income portfolios are constructed and maintained through a multi-step process.

First, a fixed-income macro-strategy committee identifies the key themes driving the global economy. The second step is for the fund managers to locate specific industries and issuers that stand to benefit from those themes. At this point, careful credit reviews are performed on specific debt issuers and loan terms are scrutinized.

“The greatest contributor to fixed income fund performance usually is sector allocation,” Robertson says. “Even within a certain credit rating, the market does not move in lock step.”

In the current environment, for instance, pharmaceutical or consumer staples companies — businesses that sell products that are considered essential in any economic environment — might face a friendlier operating environment than financial or consumer discretionary companies.

But Robertson notes that selecting the right bonds within those healthier industries also is vitally important.

“The individual bonds that we’ve picked have played a major role in our success,” says Robertson, who also manages the Northern Fixed Income Fund.

Next, portfolio managers work to get favorable trade executions, a potentially important factor in adding value for shareholders. Often, there is a significant difference between an individual bond‘s bid and ask price. Experienced fixed-income traders that buy or sell in large volume usually can get a much better deal than small individual investors trading for their own accounts.

Finally, Northern‘s research analysts and portfolio managers monitor the fund‘s positions and swap out of bonds once they‘ve achieved their price objectives, or to capture new opportunities created by changes in the macro outlook.

“The team combines a top-down macro approach with critical bottom-up analysis in constructing and managing portfolios,” Czochara says. “It‘s all about adding value at every step along the way.”

Robertson notes that mutual funds also provide a level of diversification that would be virtually impossible for individual investors to achieve in a separately managed account. Northern fixed-income mutual funds typically hold at least 100 bonds, thus minimizing the risk to the portfolio should a credit problem develop with any single issuer.

There also are questions about how much interest-rate risk to assume. The longer a fund‘s average maturity or duration, the more vulnerable it is to the damaging impact of rising interest rates. This is likely to become a concern for bond investors as the economy recovers and the Federal Reserve starts to unwind the stimulus programs introduced during the past year.

Extra spending money
Unpleasant as it was, the unusual buffeting sustained by most areas of the fixed-income market last year may have a silver lining.

Yields on non-Treasury debt — the kind most likely to benefit as bonds move into the second stage of their cycle — have risen to attractive levels, especially relative to the yield on cash investments.

Indeed, some investment-grade corporate bonds now yield an extra 7% compared with a money market fund. On a $50,000 investment, that‘s about $3,500 per year.

“Besides providing a degree of stability in a diversified portfolio, the extra income that bonds potentially generate can be useful in this tough economy,” Czochara notes.

No one knows for sure, of course, when the economic outlook will brighten. But locking in yields currently available on some high-quality corporate bonds could be one way of turning a very dark period in the nation‘s financial history into a rare opportunity.

So step on the clutch and consider shifting into second. After a tough year, it may be time to get moving.

Bond Risk: Bond funds will tend to experience smaller fluctuations in value than stock funds. However, investors in any bond fund should anticipate fluctuations in price, especially for longer-term issues and in environments of rising interest rates.