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Analysis: The Key to Protecting Principal
To compare the relative value of one bond against another, investors typically consider bond spreads.
For example, if Florida Power & Light 5.55% Senior Notes due 11/1/2017 are trading at 5.80% and the comparable 9-year Treasury is yielding 3.60%, then the spread on the FP&L 5.55s is 220 basis points.
Since FP&L is a AA-rated credit, you might first want to compare its spread to other AA-rated companies. Fortunately, several major brokerage firms maintain various corporate bond indexes that facilitate such comparisons. In our case, other AA-rated bonds recently carried spreads of about 450 basis points. (See Chart 8 below.) So FP&L’s 220 basis point spread makes it quite rich. The question that you as an investor considering the purchase of the FP&L bonds must ask is whether the low spread is worth it. In this case, highly-rated utilities like FP&L are considered less risky than say, highly-rated banks. Yet, value, like beauty, is often in the eye of the beholder.
Like most other financial market sectors, performance so far this year in the U.S. corporate bond market has been poor. Investment grade corporate bonds have been surprisingly weak, given their relatively low default probabilities. However, some of the decline has been due to forced selling by investment firms, such as hedge funds, which have been required by lenders to reduce their leverage.
As indicated in Chart 6 below, the FINRA/Bloomberg Investment Grade Index has earned a total return of -8.46% so far this year and -7.95% over the past 12 months. By comparison, the Ryan Index, an equal weighted portfolio of 2 yr.-30-yr. maturity Treasury bonds, has delivered a +7.29% total return year-to-date.
Chart 6
Total 52-Week Return for FINRA/Bloomberg Investment Grade Index
as of October 23, 2008
Source: FINRA
At its current average yield of 8.50%, the investment grade index carries a spread of 640 basis points, an increase of more than 600 basis points since the beginning of the year. At current levels, I believe that the investment grade corporate bond sector is quite attractive.
Chart 7
Total 52-Week Return for FINRA/Bloomberg High Yield Index
as of October 23, 2008
Source: FINRA
So far this year, the FINRA/Bloomberg High Yield Index has plunged 31.64%, as spreads have widened from about 725 to over 1900 basis points. Last year at this time, the spread on this index was about 500 basis points. The recent surge in spreads reflects growing concerns about rising defaults in the junk bond sector. Certainly, with the onset of a recession, made worse by the credit crisis, there will be an increase in defaults. Nevertheless, the current average yield on the FINRA/Bloomberg High Yield Index is extraordinarily high at 21.13%. Assuming that the credit markets thaw and some degree of normalcy returns to the financial markets, it is likely that the high yield market will recover. So buying a broad-based high yield fund at current low prices should produce good returns in the short-run. Over the long-term, however, individual bond selection is likely to be much more important.
KEY TERMS:
Yield Spread: a bond’s excess yield, measured in basis points, over the comparable maturity Treasury security. This excess yield represents compensation to the investor for assuming certain risks, including the possibility of default, sub par trading liquidity and higher than anticipated inflation.
Chart 8
Spreads on Various Corporate and Agency Bond Indexes
as of October 23, 2008
Source: Wall St. Journal Online
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Analysis: The Key to Protecting Principal
________________________________________________________________________________________________
Updated October 26, 2008
Stephen P. Percoco
Income Builder
P.O. Box 1409
Mashpee, MA 02649
(732) 763-0763
incomebuilder@larkresearch.com
© 2008 Lark Research, Inc. All Rights Reserved. Information is carefully compiled but not guaranteed to be free from error. Specific reference to any specific security should never be construed as a solicitation to either buy or sell. Reproduction without permission from the publisher is prohibited.