Stock Managers Go Bonkers over Bonds

Corporate bonds have the stock guys salivating. At Morningstar's 2009 Investment Conference (held May 27-29), we heard from stock managers who are finding great buys in the bond world.

Russel Kinnel 01.06.2009
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Corporate bonds have the stock guys salivating. At Morningstar's 2009 Investment Conference (held May 27-29), we heard from stock managers who are finding great buys in the bond world. A couple months ago yields peaked in the hefty double-digit range and many are still offering sizable yields.

To a stock manager, that means that they could potentially earn returns that beat typical equity returns yet have less risk because you just need the company to pay off the bond. It makes a lot of sense to me. If you're researching a company that you like and find an attractively priced bond, you could net a solid return. To be sure, even a high-yielding bond has more limited upside than stocks, which can double or triple if you're lucky, but that seems like a pretty good trade-off.

Gregg Wolper wrote recently about how many investors wish that their managers could move to cash in order to time the market. I'm wary of that because few managers can time the markets. I'm fine with managers whose discipline is to buy only when they find attractively priced stocks and keep the remainder in cash waiting for better opportunities.

However, corporate bonds seem like a more natural fishing pond for stock managers. They're just expanding the reach of their research and moving along the capital structure to find the most attractive spot to invest. Fairholme's (FAIRX) Bruce Berkowitz said he's never seen bonds so cheap. He's finding some senior bonds with big double-digit yields. "In the same way that stocks are the most junior of bonds, bonds are the most senior of stocks," he said. His point is that there's a lot of similarity there only you get to be first or close to first in line in the event of bankruptcy, whereas stockholders get the dregs.

Sure, you could point to GM as an example of when everyone got dregs, but that doesn't mean savvy investors can't do better.

I like corporate bonds in a stock fund more than cash because they are also a closer cousin in terms of behavior to stocks than cash is. High yield has historically had correlations somewhere between equities and bonds. So, from a portfolio building standpoint, this shouldn't throw you for a loop.

This isn't a novel idea. Some funds have long considered the whole capital structure but if yields remain high, I wouldn't be surprised to see more of it. Two managers who have long done this said they're finding some good deals in debt.

Marty Whitman, manager of Third Avenue Value (TAVFX), has been buying up bank debt of companies that look like good bets. As a vulture investor he's long been attracted to cheap bonds and loans in part because of their place in line in the event of bankruptcy. He's earned excellent returns buying K-mart debt among other things, and this current economy and market environment should provide more of such opportunities.

Likewise, Steve Romick of FPA Crescent (FPACX) has invested anywhere in the capital structure that looks attractive. (He also shorts stocks.) Romick said he's been doing a lot of bond buying though he notes that many high-yield bonds got away from him because there were limited sellers at prices low enough to entice him.

Romick's latest shareholder letter highlights some of his recent bond investments and illustrates how he looks at them. For example, he bought International Lease Finance Corp. debt at yields to maturity above 25% and Interpublic Group debt "at a super attractive 20% yield-to-worst call."

As for ILFC, he takes a realistic look at the pluses and minuses: "We maintain that ILFC has adequate liquidity given that the government will support ILFC as long as ILFC is part of AIG. If, however, the government does not backstop ILFC or if the company is sold, then ILFC still has access to vendor financing as well as secured airplane financing. Several of ILFC's airline customers may go bankrupt during this recession; however, since all ILFC's leases are operating leases, they should not become part of bankruptcy proceedings, thereby limiting our concern regarding their customers' balance sheets. Furthermore, in the event of customer non-payment, ILFC can quickly seize their airplanes and hopefully re-lease them. ILFC has a proven management team and one of the youngest, most in-demand airplane portfolios in the world, the value of which should hold up well even under a severe economic downturn. At the cost of our debt, we have effectively created ILFC's aircraft portfolio at more than a 45% discount to its depreciated book value, a level we deem to provide reasonable asset coverage."

I like managers who can take advantage of what the market's giving them. If corporate bonds are a screaming buy, I hope some of my funds are adding to their position

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Russel Kinnel  Russel Kinnel is Morningstar's director of mutual fund research.

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