A Slam-Dunk Trade for 2009

If you follow the markets closely, you come across unusual situations from time to time. They are unusual because they appear so obviously profitable that they remind one of the joke about the finance professor who tells his student not to bother picking up a $100 bill lying on the sidewalk -- after all, if it were a $100 bill, the 'market' would have picked it up already.

In this instance, the undervalued asset is investment-grade corporate bonds (before your eyes glaze over, let me assure you that this is valuable even for stock investors). Indeed, credit risk, that is, the risk of an issuer defaulting on a bond, is being dramatically overpriced … which isn't surprising since we are currently watching the bursting of arguably the largest credit bubble in history.

Fear has flooded the capital markets
We certainly shouldn't expect to go from a huge underpricing of credit risk (during the bubble build-up) -- in mid-2007, investors required less than 2.5 percentage points in extra yield compared to U.S. Treasuries in order to hold junk bonds -- to rational pricing. Where there was previously no fear of default, we are now in a period in which the fear of a loss of principal has flooded every nook of the capital markets.

Investors have sought refuge on the only high ground they could think of: U.S. Treasury bonds. As a result, government bonds are now overpriced. As strategist James Montier noted in his first report for 2009: "From my perspective as a long-term value-orientated investor, [U.S. government] bonds simply don’t offer any value… If yields were to rise from 2% to 4.5% investors would stand to suffer a capital loss of nearly 20%." Not a pleasing prospect.

The flight away from corporate debt (and all other risky assets) into government bonds has created a situation in which investment-grade corporate bond spreads (the difference in yield between corporate and government bonds) have reached levels not seen since 1932 -- one of the worst years for the U.S. economy in history and a great time to buy bonds. The following table contains examples of blue-chip issuers:

Issuer

Bond Yield

Spread over U.S. Treasury Bond Yield

Alcoa (NYSE: AA  )

7.18%

626 basis points

Dow Chemical (NYSE: DOW  )

6.92%

553 bps

Bank of America (NYSE: BAC  )

5.50%

349 bps

Home Depot (NYSE: HD  )

5.37%

336 bps

JPMorgan Chase (NYSE: JPM  )

4.70%

331 bps

Target (NYSE: TGT  )

5.45%

308.5 bps

General Electric (NYSE: GE  )

5.24%

290 bps

Is there any way for individual investors to take advantage of this mispricing? Sure. Using exchange-traded funds, you could, for example, go long the iShares iBoxx Investment Grade Corporate Bond Fund ETF and short the iShares Lehman 7-to-10-year Treasury Bond Fund. However, that trade is best suited for the professional investor.

A hint to stock investors
Nevertheless, there is a lesson here for individual investors. After all, corporate bonds are not the only risky assets out there. If they are being undervalued, that's highly suggestive that equities are also undervalued (not in aggregate, necessarily, but specific sectors, certainly). For investors who have cash ready to deploy at a time when risk aversion is at a peak, the current environment is rich in opportunity.

More Foolishness:

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Alex Dumortier, CFA has a beneficial interest in Home Depot but not in any of the other companies mentioned in this article. JPMorgan Chase, Dow Chemical, and Bank of America are Motley Fool Income Investor selections. The Home Depot is a Motley Fool Inside Value pick. Try any of our Foolish newsletters today, free for 30 days.The Motley Fool has a disclosure policy.


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  • Report this Comment On January 07, 2009, at 5:46 PM, JakilaTheHun wrote:

    Good article. However, my concern is this --- would buying into corporate bonds yield enough of a return to protect against inflation?

    With the way the government is spending right now, I'd rather buy into stocks because the market will inflate (to at least some extent) with the Dollar.

  • Report this Comment On January 07, 2009, at 6:14 PM, EnigmaDude wrote:

    If you buy an ETF that includes high-yielding corporate bonds, such as HIO or CYE, then you get paid to wait for the fund to generate that inflation-beating return.

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