A limited-time, golden opportunity in bonds

When recessions end, there's a brief opening for the astute investor

By Thane Stenner
Thane Stenner is the founder of Stenner Investment Partners within GMP Private Client LP , as well as Managing Director, Private Client. He is author of True Wealth: An Expert Guide for High-Net-Worth Individuals (And Their Advisors). stennerinvestmentpartners.com thane.stenner@gmppc.com

Globe Investor Magazine Online, March 24, 2009


If there's one thing specialist bond managers are talking about, it's the opportunity to earn outsized returns with investment-grade corporate and high-yield bonds.

These managers believe much of the downside risk has already been baked in to the bonds' prices, and current yields are close to record highs. This presents an opportunity for high-net-worth investors such as "Bill" and "Dorothy," whom I met with for a portfolio review in January.

Bill is the retired chairman of a public company, and Dorothy is his wife (their names and some non-essential details have been changed to respect client confidentiality). Bill sold a concentrated position in company stock when he retired, and the couple now live on the income from their well-diversified portfolio.

In previous years, the bond portion of their portfolio has been built on government issues, an allocation that would amount to perhaps $5-million out of a $12-million portfolio. This year, we recommended an allocation of between 10-to-30 per cent of the total portfolio to investment-grade corporate and high-yield bonds. Why?

Obligations to bondholders take precedence over obligations to stockholders in the case of financial disaster, and these bonds are a better way to protect capital in the current environment. Right now, investors don't have to give up much for that protection - because of fear over defaults, investors can enjoy equity-like returns (7 to 9 per cent for investment grade; 15 to 16 per cent for high yields globally) by actually moving up the capital structure.

There's also the issue of pricing: Currently, the market is assuming we are on the verge of another Great Depression. Corporate bonds are currently priced five to six percentage points over U.S. Treasury bonds, while high-yield bonds are priced between 14 to 16 points above the Treasuries.

However, high-yield bonds actually outperform equities in the first few years following a recession - the average compound return for three years following the past three recessions was 18 per cent. In addition, high-yield bonds are often the first asset class to recover after a recession. First to recover, and you get paid well to wait - it's an attractive proposition.

Bill and Dorothy were swayed by these arguments. With his corporate experience and connections, Bill knows big business is hurting, but it isn't dying.

He saw the benefit of taking advantage of the pessimism. The only question that remained was how.

Most investors will be best served by an experienced manager with a good track record, who can sift through bond offerings, analyze creditworthiness and perform due diligence. A manager also provides a diversified portfolio of perhaps 50 to 100 bonds - an essential benefit in a deep, enduring recession that will almost certainly see defaults.

We currently utilize the following with our high-net-worth clients:

Mackenzie Sentinel Corporate Bond: A solid fund headed by a disciplined management team with a noted conservative approach. The safety-first approach is particularly noteworthy, as is the fund's use of currency hedging.

O'Leary Global Income Opportunities: Kevin O'Leary is at the helm of this fund, which also invests in preferred and high-yielding shares and distressed debt. Simply put, his team is exceptionally good at what they do.

Arrow High Yield Bond: This fund is able to go long on investment-grade corporate and high-yield bonds, and is also finalizing a paired trading strategy so it can short government issues. This is especially attractive given the possibility for a "bubble" in U.S. Treasury bonds.

Corporate bond ETF: An ETF can be used for inexpensive, passive exposure. It's also an easy choice for investors with more modest portfolios.

The window for investment-grade corporate and high-yield bonds won't remain open for long, as prices have climbed by as much as 12 per cent in the past few weeks as investors recognize the opportunity at hand. Now is the time for action.

Special to the Globe and Mail