Look to Incorporate Corporate Bonds

It's hardly a news flash that last September's financial industry upheaval took the phrase "crisis of confidence" to a whole new level in the bond market. As investors worldwide sold riskier assets in a mass stampede to safety in the months that followed, Treasuries reigned supreme while bonds without government backing got clobbered. That explains how  Vanguard Long-Term U.S. Treasury (VUSTX) could deliver a whopping 23% gain in a year where the typical diversified bond-fund manager faced an uphill battle just to break even (roughly 60% of the funds in Morningstar's intermediate-bond category suffered losses in 2008). High-yield corporate-bond funds have fared even worse, shedding 26% of their value, on average, in 2008.

Although Treasury rates have begun to rise off their lows in recent weeks, few could argue that their still-anemic yields--whether just several tenths of a percent on the three-month Treasury bill or 2.40% on the 10-year note--have much to offer long-term investors, particularly as government policies aimed at getting the economy back on track could stoke inflation. And with nowhere for Treasury yields to go but up, Treasury-heavy funds that won big in 2008 could easily become tomorrow's losers (as yields rise, prices on outstanding bonds fall).

That isn't the case for the corporate sector, though. In October and November, some investment-grade corporate bonds have offered yields as high as 8% or 9%, representing an additional 5 to 6 percentage points over Treasuries. The average yield on junk bonds recently climbed higher than 20%, setting a new record. We've heard analysts and investors estimate that these prices reflect corporate defaults spiking to worse levels than those seen during the Great Depression, a view many think is overly pessimistic. Although corporate bonds have recovered some ground in recent weeks--as of Jan. 8, the yield on the Barclays Capital U.S. Corporate Investment Grade Index had dropped to 7.3%, down from 9.1% at the end of October, and the Barclays Capital High Yield Index currently yields 18%--many managers argue that there's still plenty of value to be had in the corporate sector.

Still, plump double-digit yields on junk bonds aren't exactly a no-brainer for investors. With the economy continuing to deteriorate, there's almost certainly more pain to come in the form of defaults. Another question mark is the amount that a bond investor can expect to recover in the event that a company actually does go bust. Some investors are concerned that the torrent of senior bank loans issued in recent years--which have a higher priority claim on a company's assets--could take a bite out of how much investors have historically expected to recover from a default (close to 40 cents on the dollar for senior unsecured debt, according to Moody's). The frozen credit markets could also prove especially challenging for high-yield issuers, which rely heavily on debt financing to keep their businesses going. If the market doesn't thaw soon, companies that need to refinance their debt in coming months could find the crippling cost of issuing new debt insurmountable. As an added wrinkle, mutual fund investors have to contend with the risk that their fellow shareholders could lose their nerve and head for the exits, causing fund managers to sell bonds at distressed levels.

Although mistakes may be nearly impossible for high-yield bond-fund managers to avoid in the year ahead, those managers who do a good job of dodging the most troubled firms should come out ahead. Our favorites in the category--like  Fidelity High Income (SPHIX),  T. Rowe Price High-Yield (PRHYX), and  Vanguard High-Yield Corporate (VWEHX)--make appealingly restrained, well-supported options for more-intrepid investors to get high-yield exposure.

For investors who are nervous about the rocky road ahead for high-yield, the good news is that many managers actually like the prospects for investment-grade corporate bonds even more. The following three funds are top choices for investors interested in adding some corporates into their own portfolio mix.

 Dodge & Cox Income (DODIX)
We'd recommend this fund for those who want corporate exposure in a tamer, more diversified package. With more than a third of assets in corporate bonds (mostly investment-grade), the fund has one of the higher corporate weightings in the intermediate-term bond category, and we think the Dodge & Cox team's company-specific analysis is among the very best in the business. Lately, it has redoubled its efforts to research current holdings' short-term cash needs, and it has continued to identify and add corporates in recent months when it spies good long-term value.

 T. Rowe Price Corporate Income (PRPIX)
This offering is one of the few funds around to focus almost entirely on investment-grade corporates, even if its emphasis on the lower end of the investment-grade spectrum does court more credit risk (60% of the portfolio was rated BBB as of Sept. 30). We're confident that T. Rowe Price knows what it is doing on the credit research front, though. When we last checked in with manager David Tiberii in November, he was making a case for the debt of large banks and (former) brokers, arguing that such firms' bonds should make better bets than their common stock over the next several years. Factors like less leverage and more regulation, while not necessarily a boon for earnings growth, are positive developments for bondholders.

 Loomis Sayles Bond (LSBRX)
Like high-yield funds, this bold multisector-bond fund can require plenty of patience--its 22% loss in 2008 offers plenty evidence of that. But in the extremely unsettling market of recent months, the venerable Dan Fuss and his comanagers have kept their heads, calmly going about their usual business of identifying beaten-down corporate bonds that stand to benefit from a longer-term economic recovery. (The fund held 45% in investment-grade and 19% in high-yield corporates as of Nov. 30.) Investors who share Fuss and team's long-term mind-set and taste for adventure will like what they find here.

This article originally appeared in the December issue of Morningstar FundInvestor.