from Barrons this weekend

Capital Markets --- Current Yield: Bondholders Got Chicken Feed in '05
By Tom Sullivan
2 January 2006
Barron's
M9


It may have been the year of the rooster in the Chinese lunar calendar, but there was little for U.S. fixed-income investors to crow about in 2005.
Rising interest rates, a flattening yield curve that finally inverted last week and a newly nominated sheriff at the Federal Reserve provided the backdrop. The incredibly shrinking credit quality of General Motors (ticker: GM) and the rest of the auto sector provided the drama.
Outgoing Federal Reserve Chairman Alan Greenspan proclaimed a "conundrum" in February as long-term rates failed to rise as the central bank steadily raised its federal-funds rate target, now at 4 1/4%. Investors, he warned later, weren't being rewarded sufficiently for their risk-taking.
The Treasury component of the Lehman Brothers U.S. Aggregate Index for intermediate maturities returned barely than 1.5% in 2005, which was "rather disappointing," says Gary Pollack, a managing director at Deutsche Bank Private Wealth Management. The huge U.S. trade deficit piled dollars offshore, which foreign central banks plowed back into U.S. investments, including Treasuries and the implicitly federally guaranteed debt of mortgage lenders Fannie Mae (FNM) and Freddie Mac (FRE). "Without foreign investment, 10-year [Treasury] yields would be 100 basis points [one percentage point] higher," he reckons.
The interest-rate outlook is uncertain, although Pollack expects incoming Fed Chairman Ben Bernanke to raise rates at the March meeting of the Federal Open Market Committee -- his first as the boss -- so as "to be inducted into the fraternity" of inflation fighters.
Yet even with rising rates, the economy turned in a solid performance and Corporate America enjoyed good profits in 2005 -- except for the battered auto and auto-parts makers.
For GM, the Year of the Dog came nearly a year early. Last March, GM issued a shockingly weak financial forecast for the first quarter and full year. By May, Standard & Poor's had pulled the plug on its investment-grade ratings for both GM and Ford Motor (F) and their finance units. At year end, they were all deemed junk and out of the Lehman index.

The sheer size of their combined debt load had high-yield bond investors worried the new supply would overwhelm the much smaller junk domain. It looked like "a camel going through the eye of a needle to get to heaven," said Andrew Feltus, portfolio manager at Pioneer Global High Yield Fund. "It was a very volatile year," he said.

While GM and Ford went to junk, former GM subsidiary Delphi (DPHIQ) joined fellow auto-parts supplier Collins & Aikman (CKCRQ) in bankruptcy court. They were just two of several high-profile bankruptcy filings in 2005. Delta Air Lines (DALRQ) and Northwest Airlines (NWACQ) both filed on the same day -- Sept. 14. A month earlier, Anchor Glass Container (AGCCQ) filed for Chapter 11 bankruptcy protection. And Calpine (CPNL) filed in December -- surprising investors who had grown accustomed to the long-troubled company muddling through.

But what looked like a feast for vultures -- investors in debt that trades at depressed levels -- was barely a snack, at least for some. "We haven't seen the opportunities" for value investing, said Michael Embler, chief investment officer of Franklin Mutual Advisers, with assets that include distressed debt. But the outlook should improve, as defaults start to rise from their historically low levels, he added.

Back in 2003, a lot of highly risky debt began to be issued as the market began a nearly three-year rally and investors scrambled for yield. A rule of thumb in the junk-bond market is that many of those types of deals start to unravel in three years, as business plans prove unworkable.

Opportunistic investors are also eyeing collateralized debt obligations, instruments formed by repackaging other debt, such as junk bonds, to create higher-rated debt.
Yield margins on CDOs are "ridiculously tight," says Mirko Mikelic, senior fixed-income analyst and portfolio manager at Fifth Third Asset Management. He's waiting "for the shakeout" that will follow an uptick in defaults before he starts buying. CDOs, as well as mortgage-backed, commercial-mortgage-backed and other asset-backed securities, did well in 2005 because of the low volatility in Treasuries and a "tremendous bid" from overseas, Mikelic says.

By far, the best fixed-income performer was emerging markets, with JPMorgan's Emerging Markets Bond Index Plus up 11.8% through Wednesday. The rally was "relentless, regardless of good news or bad news," said Pioneer's Feltus. "Valuations started the year at historic [narrow levels] and are tighter today," he said.

Oil producers such as Colombia and Russia were helped by crude prices around $60 a barrel. Plus, countries like Brazil and Turkey boast improved government balance sheets and better fiscal and monetary policies, Feltus adds. Still, there are a number of elections to be held in 2006 in Latin America, and some candidates for high office have picked up the leftist flag of Venezuela's Hugo Chavez.

The broad fixed-income market faces challenges in the new year as well. The inverted yield curve -- at week's end, the yield was 4.38% on the two-year Treasury, 4.37% on the 10-year -- has often in the past augured a recession in the U.S., which would roil investment-grade corporates and junk bonds in particular.
But Deutsche Bank's Pollack doubts the economy is ready to pull back. "It's different this time," he says. "It's not the yield curve, but tight monetary policy" that causes recessions, he said. With fed funds at 41/4%, even rising to 43/4%, "it's not that tight," Pollack said.
Even if the economy chugs along, corporate-bond investors will be wary, as evidenced by the explosive growth in the credit-default swaps market, where investors can insure their bonds. That's because shareholders want their piece of the pie after years of watching corporations shore up their balance sheets.
DuPont (DD) provided a dramatic example, as it announced plans in October to buy back $5 billion of its common stock over two years. That prompted the three major credit rating agencies to slash its corporate debt rating by three notches to the equivalent of single-A from double-A.
Low stock prices will also entice private equity investors, flush with record amounts of cash in 2005, to scour for potential acquisitions, often by loading a company with debt as part of a leveraged buyout, leaving holders of the outstanding bonds with weaker ratings and prices.
Merger and acquisition activity and other shareholder-friendly acts are becoming such a fear that corporate bond investors began to fight back.
Temple-Inland (TIN), a target of shareholder activist Carl Icahn, was required in late November to redress investor fears about a potential LBO when it sold $500 million of bonds by including a provision to increase its coupon payments if its ratings are cut to junk.
Bond investors "have long memories," said Barbara Cappaert, analyst at Montpelier, Vt.-based KDP Investment Advisors. "But if you pay the right price, they'll forgive you."