One Way to Find Value in Today’s Low-Rate Environment

low rate investmentsDespite the rise in benchmark Treasury rates during the month of May, it is still difficult to find the corporate bond market wildly attractive at today’s levels. With market-wide spreads still at less-than-attractive levels and broader-market yields not far off all-time lows, it is quite challenging to find a lot of value. But it can be done.

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In the stock market, it is not unusual for individual stocks to do their own thing, deviating from the general direction of the broader market. Apple’s horrific stock price action that began last fall is a good example of how even a mega-cap stock’s performance can diverge from that of the major indices. In the world of fixed-income, the same is also true for an individual company’s bonds. Even when broader-market spreads are contracting, an individual company’s bonds could be experiencing spread widening. Even when benchmark rates are falling, one particular company’s bonds could have rates that are rising. And it is therein that an opportunity lies.

Yes it is true that corporate bond spreads are sitting around levels one might consider average (or close to average) from a historical perspective. And yes, it is true that market-wide yields are not very far from all-time lows. If you are a fixed-income investor, this means you should shy away from putting new money to work in bond funds and instead focus your efforts on individual bonds. Furthermore, rather than aggressively dispersing your funds across a multitude of individual bonds, it may be more useful to search for those bonds that have gone against the grain and experienced an above-average spread widening.

Two examples of companies whose bonds experienced spread widening late last year are Best Buy and Hewlett-Packard. Of course, significant spread widening and corporate bond yields bucking the trend of benchmark yields does not happen when the financial markets are upbeat on the prospects of a company’s business. Best Buy and Hewlett-Packard both went through periods during which the negativity surrounding their future business prospects was widespread and deep enough to push not only their stocks lower but also their bonds lower (lower in price, higher in yield). Regardless of whether Best Buy and Hewlett-Packard have the potential to return to their glory days, if you were of the opinion that both businesses could simply avoid default, you were presented with a wonderful buying opportunity. Another example from last year is AngloGold Ashanti’s bonds, which experienced spread widening during the South African mining industry strikes. Nokia also provides a good example of a company with bonds that experienced significant spread widening in 2012, only to eventually recover. When things settled down, the spread widening reversed. A more recent example is Barrick Gold’s bonds. Although the company’s stock was first to take a hit, due both to issues with the Pascua-Lama mine and lower gold prices, Barrick Gold’s bonds eventually played catch up.

If you can find these types of examples among the thousands of individual corporate bonds trading in the secondary market, and you believe the companies whose bonds are experiencing spread widening will be able to avoid default, you will find yourself value in a fixed-income world in which finding value has become rather difficult. So how do you find examples of spread widening? If you don’t have software that easily displays individual bond spreads, you will have to take a more time-consuming approach.

One place to begin is to look for individual stocks that are noticeably underperforming the major indices. Among the companies with underperforming stocks, there is a good chance you will also find underperforming bonds. Furthermore, establishing a set of criteria you hope to find in a bond and frequently running a screen on your broker’s platform looking for bonds corresponding to your criteria is another way to find examples of spread widening. I run the same bond screen nearly every day and have gotten to know which bonds typically show up in the results. When new bonds appear in the results, I check to see if spread widening or a rise in benchmark yields was the reason for the newly-appearing bonds. Third, for those bonds you are considering purchasing, you can keep track of the daily closing yields (based on the closing offer, not the last trade) and compare the change in yield to the change in the benchmark Treasury rate. This could be done on a daily basis, or even just every few days. It is a more time consuming way to find value in the bond market, but it may be worth your while.

Fixed-income investors who regularly look to invest new money in the bond market know how difficult it has been lately to find widespread value. When you are not finding it across the broader markets, it is time to focus more heavily on finding it on a security-by-security basis. If you notice bond spreads widening for companies you believe are in no danger of default, and the yields being offered meet your needs, those are opportunities worth seizing. In the world of stocks, we are constantly reminded to “buy the dip.” Bond investors should not be shy to do the same. Spread widening provides opportunities for bond investors to find value in today’s low-rate environment and “buy the dip.”

More from The Financial Lexicon:

Income Investing Insider Newsletter
The 5 Fundamentals of Building a Retirement Portfolio
Options Strategies Every Investor Should Know

 

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