Pieces Falling into Place

Since the beginning of the year, we talked about how the shape of a recovery in the markets might look. We mentioned that stocks would recover before the economy does, and credit markets may recover before stocks. During this six-month credit crisis Treasury bonds held up well, but AAA corporate bonds lost 15% to 20%. Much of the Treasury and Federal Reserve’s activity has been centered around getting credit markets moving again and stabilizing our banking system.

Last week’s Treasury announcement of a market program to clean up the balance sheets of troubled banks is a sign that these pieces are finally falling into a place. We believe this is the beginning of a foundation from which corporate bond markets will begin a gradual recovery well into the future. Sure, the economy will slow, more banks will fail, and bankruptcies will occur, but look at the accomplishments of the last few months.

The Treasury’s TARP program has provided several hundred billion dollars in capital support to banks. The Federal Reserve has effectively lowered interest rates to zero percent, giving the banks incentive to lend (and investors little incentive to stay invested in low yielding money market funds). Credit spreads, which represent the difference in yield between corporate bonds and Treasury bonds, have begun to narrow. This is a sure sign that people are becoming more confident that the bond market is once again fluid.

As a result of our analysis, we have added a corporate high-yield bond fund position (2% – 8%) in order to take advantage of these opportunities. We believe an experienced, diversified, and tactical bond fund can navigate the troubled waters ahead, and provide us with both added yield and total return for our portfolios in the months ahead. We are not alone. The Investment Manager Outlook, a quarterly survey of investment pros conducted by Tacoma, Washington-based money manager Russell Investments, found 67% of managers bullish on corporate bonds and 61% bullish on high-yield bonds in general. Both categories were more popular than stocks. “In this environment of caution and realism, managers are finding opportunity in spreads between high-quality corporate bonds and Treasuries that are at historic levels,” Erik Ristuben, Russell’s chief investment officer, said in a statement.

We believe high yield bonds are a great value, selling at a 25% – 30% discount! This is our first step to a more aggressive position, with our next move to small company stocks probably coming in the next three to six months.