Corporate Bonds: Higher Return Potential, Better Portfolio Diversification

Treasuries have been the worst performing fixed income asset class over the past two months, as investors have embraced risk amid improving confidence. The Treasury market is also under pressure from a projected Federal budget deficit of $1.8 trillion in the current fiscal year. The combination of rising Treasury yields and falling yields on other fixed income asset classes has resulted in a significant narrowing of the historically wide yield “spreads” that developed in the wake of last fall’s financial collapse. Yields on junk bond indexes have dropped from 20% to 13% , while yields on investment-grade corporate bonds have fallen from nearly 9% to under 6.5%.

At current yield levels, investment-grade corporate bonds provide a much better combination of return potential and portfolio diversification benefits than junk bonds. Short to intermediate term maturities are favored to limit interest rate risk. Pricing anomalies in the municipal bond market have largely been corrected. Today, a 10-year, AAA-rated general obligation municipal bond yields approximately the same as a 10-year Treasury bond. In late 2008, such municipal bonds could be purchased with yields 175% those of 10-year T-notes.