"Valuable Corporate Bond Exposure"

The media focuses most of its attention on the stock market when it comes to investments.  The Dow or S&P 500 has often been the benchmark for the health of the economy.  They are also the most widely known indexes to the average investor.  But what about the investment grade bond index or the high yield bond index? How important are these to the average investor?  Since we evaluate asset classes when allocating clients' money, it is important that we monitor all areas of the investable market.  A huge component of that overall evaluation is the bond market.  After a major selloff during 2008, there has been a subsequent rally in 2009 that has benefited both bond and stock holders.  Bonds are often less appealing to investors because they are viewed as conservative investments with lower investment returns.  With relatively attractive current yields, less volatility, and low inflation, we have been significantly invested in corporate bonds for most of the year and expect to continue to be invested at least for the near future.

After the collapse of Lehman brothers in September of 2008, the bond market (like the stock market) took a major hit.  The selloff in bonds outside of U.S. Treasuries sent the prices of bonds tumbling.  Those investors that ventured back into the corporate bond market at the end of 2008, or early 2009, were rewarded with high yields to compensate for the market risk.  Since the market has recovered, the prices of these bonds have risen with increased demand, lowering yields, while providing investors with capital appreciation.  Although most of the capital appreciation in bonds has been made, there is still some room for prices to go up, given a growing economy.  As corporate bonds are yielding about 5+%, they are still relatively attractive when compared to U.S. Treasuries, money markets, and CDs.  The risk of default with corporate bonds has lowered significantly as corporations have raised cash via bond and equity offerings to improve their balance sheets.  

At Legacy Wealth Management we manage portfolios based on risk.  Given the current fragile economic environment, we find great value in holding corporate bonds that produce income for our portfolios while reducing the portfolios' overall risk and increasing diversification.  Both investment grade and high yield corporate bonds are less volatile and carry significantly less risk than equities.  The lessened risk is evident when looking at the returns over the investment periods presented in Exhibit 1 below.  Corporate bonds didn't perform very well during the down market periods of 2008 and early 2009 but held their values much better than their equity(stock) counterparts.  This is particularly evident when looking at performances over the entire period presented.  During the market rebound this year, corporate bonds didn't rally as hard but still produced solid gains for our clients.  Should there be a correction in the market, our bond positions should hold their values relatively well in comparison to stocks while continuing to pay our clients monthly interest payments.  We favor higher quality investment grade bonds, as we believe risk of default will continue to remain higher than the historical averages until the economy rebounds substantially.  At the same time, we still hold some higher yielding bond funds which should benefit with the recovering economy.  In addition, high yielding bonds add protection against rising interest rate risk.

Exhibit 1

Note:  Returns calculated based on data obtained from the S&P website and Bloomberg.  S&P 500 TR utilized for ‘Stocks'. 

IBOXIG Index utilized for ‘Investment Grade Bonds'.  IBOXHY Index utilized for ‘High Yield Bonds'.

With interest rates at historic lows and the government's injection of massive amounts of money into the economy, some believe inflation is just around the corner.  Given the inverse relationship between interest rates and the value of bonds, an increase in interest rates by the Fed would have negative effects on the bond funds we own, especially the higher-graded corporate bonds.  The unemployment rate recently dipped down from 10.2% to 10.0% and manufacturing production increased for the fourth straight month according to the Institute for Supply Management,¹ prompting some to speculate that inflation could be a near term risk.  However it is way too early to call economic victory and the Fed echoed that viewpoint in its Federal Open Market Committee minutes from its December 16^th meeting.  The Fed acknowledged an improving economy but said that the ‘low rates of resource utilization', or employment, and ‘subdued inflation trends' should keep interest rates at low levels for an ‘extended period'.²  The increased lending of money along with increased resource utilization could cause inflationary consequences.  However, credit remains tight and business spending is still cautious.  Consumers continue to be more frugal, which will also keep downward pressure on prices of goods.  In fact, outside of food and energy, the ‘core prices' of the consumer price index was unchanged in November.³  Until there is significant evidence that the employment situation in our country is improving, we expect the Fed to hold tight with current rate levels in fear of a double dip recession. 

With that said we continue to hold onto our corporate bond positions.  Substantial gains in our bond funds could lead us to rebalance sooner, but we expect to maintain exposure until evidence convinces us otherwise.   According to the Investment Company Institute, bond mutual funds continued to accumulate assets from investors for the 11^th consecutive month.  Investors continue to be nervous about the stock market and invest in less risky, income producing bond funds, so there is strong momentum in the bond market.  We continue to have equity exposure but will also continue to invest in less risky investments like corporate bonds that add diversification to portfolios and produce income for our clients.

• 1 "November 2009 Manufacturing ISM Report on Business." http://www.ism.ws/ISMReport/MfgROB.cfm?navItemNumber=12942 December 16, 2009.
• 2 "Press Release." http://www.federalreserve.gov/newsevents/press/monetary/20091216a.htm December 16, 2009.
• 3 "Consumer Price Index Summary." http://www.federalreserve.gov/newsevents/press/monetary/20091216a.htm December 16, 2009.