Can These Investments Keep Flying High?

Lately, trying to find stocks that will deliver double-digit returns year after year has become a lot harder. That's why you might want to look beyond stocks to try to find good performance.

Back in the early 1980s, you didn't have to work too hard to earn 10% returns. In fact, all it took was a single investment -- in a Treasury bond. With interest rates at incredibly high levels, you could buy a 30-year Treasury and then sit back and watch the interest payments come in over the years.

Of course, there was good reason why Treasuries paid so well back then. Double-digit inflation required borrowers to pay attractive interest rates to find lenders. Today, although you won't find any bonds paying anything close to 10% among Treasury issues, you can find attractive interest rates in a different part of the bond market: corporate debt.

Reversal of fortune
Last year, corporate bonds performed terribly, as spooked investors gravitated toward higher-quality debt and accepted extremely low yields to avoid any speck of default risk. But this year, investors are looking at the other side of the coin -- and as stocks have recovered much of their losses from earlier in the year, so too have corporate bonds bounced back from their ugly performance in 2008, especially in the high-yield "junk bond" sector. According to Bloomberg, one high-yield bond index has posted returns of more than 28% so far in 2009, compared with a 25% loss last year.

Although the junk bond market has shown particular strength, you can see the strong performance that higher-quality corporate bonds have offered as well. Here are some examples of bond mutual funds that have cashed in on this trend:

Fund

2008 Return

2009 YTD Return

Bond Holdings Include Issues By ...

Vanguard High Yield Corporate (VWEHX)

(21.3%)

20.4%

Qwest (NYSE: Q  ) , NRG Energy (NYSE: NRG  )

Fidelity Intermediate Bond (FTHRX)

(5.8%)

9.6%

Altria (NYSE: MO  ) , Citigroup (NYSE: C  ) , General Electric (NYSE: GE  )

Goldman Sachs High Yield A (GSHAX)

(27.6%)

25.2%

DirecTV (NYSE: DTV  ) , Hologic (Nasdaq: HOLX  )

Source: Morningstar.

Investors who were able to stomach the sharp losses in corporate bonds last year have been rewarded for their patience. Meanwhile, anyone who jumped ship and fled to the "safety" of Treasuries took a second hit, because high-quality Treasury bonds have brought substantial losses so far this year.

Can the good times last?
One reason why corporate bonds in general, and high-yield bonds in particular, have done as well as they have is because of the big spreads -- the difference in yield between those type of investments compared with Treasury bonds -- that prevailed in the market in late 2008. Those spreads have been cut in half just since December. Also, it doesn't hurt that high-yield bonds are expected to have a default rate of 13.8% in the fourth quarter, requiring borrowers to offer higher yields to lenders.

Yet as big a drop as that sounds, yield spreads still have plenty of room to fall further. After a spread of more than 20 percentage points between Treasury and junk yields, the current level of 11 percentage points may seem slim by comparison. Similarly, a drop in spreads from from 6.56 percentage points to 3.33 for higher-quality corporate bonds could lead you to conclude that you're no longer getting paid enough in additional interest to warrant the default risk involved -- especially during a recession.

However, just because spreads have come down doesn't mean that they'll go right back up anytime soon. In fact, corporate bonds are arguably less vulnerable to several risks common to bonds:

  • Rising interest rates are never good for bonds. But even if Treasury yields rise -- as they have throughout much of 2009 -- high spreads can insulate corporate bonds, and as we've seen this year, if spreads contract, corporate bonds can make gains even in a rising-rate environment.
  • Default risk is a constant worry for corporate-bond holders, especially on the high-yield end of the market. But with stocks having rebounded, many debt-laden companies have had an opportunity to refinance debt by offering new shares, cutting back their debt loads and making their survival more likely.

Meanwhile, corporate-bond holders get a reward every day from the higher interest their holdings pay them.

Profit with care
Corporate bonds look attractive to income-hungry investors. Although you've clearly missed the best time to buy, smart investors can still find profitable investments among bonds. As long as you understand the risks involved, owning corporate bonds either directly or through a bond exchange-traded fund or mutual fund can give you higher yields on your money.

For extra info on earning more income from your portfolio:

Our Motley Fool Income Investor newsletter constantly seeks the best income-producing investments. Take a free look at our current recommendations today with a 30-day trial -- just click here to get started.

Fool contributor Dan Caplinger likes including some corporate bonds within his fixed-income portfolio. He owns shares of Altria, General Electric, and Vanguard's High Yield Corporate Fund. Try any of our Foolish newsletters today, free for 30 days. There's no chance of default on the Fool's disclosure policy.


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