All-Weather Bonds
Marilyn Cohen, Forbes Magazine, 01.14.09

Junk is still at risk for stormy weather. Here are some safer things to look at.

IF EVER THERE WERE A NUCLEAR WINTER FOR INVESTORS 2008 was it. Even the somewhat conservative recommendations I made got annihilated. One day the preferred shares of Freddie Mac and Lehman Brothers were considered to be smart money speculations; the next day they were nearly worthless. You can thank Secretary Henry Paulson's panic attack for that. In September he suspended the preferred dividend payments for Fannie Mae and Freddie Mac when it was placed into conservatorship. With Lehman, Paulson allowed an overnight implosion, thereby causing $75 billion of damage that wouldn't have occurred with an orderly wind-down of this firm (according to Lehman's restructuring firm, Alvarez & Marsal).

Then, perhaps realizing his mistake, Paulson thought he could make things right by saving AIG, allowing it to continue paying its preferred dividends. But when the most powerful financial official in the world is waffling, is it any wonder that the market for preferreds and other fixed-income investments remains broken, even today?

My 2008 record was a disappointment. Had you purchased all the 18 securities I recommended in this column and shorted the 3 that I panned, you would be down 8.2% as of Dec. 31. (This number includes coupons and dividends and is after a hypothetical 1% transaction cost.) Investments in Merrill Lynch broad bond market index, or its muni index when I was recommending a municipal bond, would have returned 2.9%. I'm not happy about my performance, but I am proud of the advice I gave in my July column, "Trouble in Junk Land." Contemplating the coming wave of corporate defaults, I told you to sell any junk-bond-related investment. I hope you listened. One ETF I specifically mentioned selling, PowerShares High Yield Corporate (PHB), is off 36% since then. Today the yield spread of the Merrill Lynch High Yield Master II Index (with an average credit quality of B2) over Treasurys is 17 percentage points. It was only 8 points when I wrote that column.

One such candidate is an odd-duck company called National Rural Utilities Cooperative Finance Corp. National Rural lends money to 1,500 electric cooperatives, most of them small power providers like Spokane, Wash.'s Inland Power & Light and New Hampshire Electric Co-Op in Manchester. Nearly 90% of National Rural's loans are secured. This issuer's managers are on a tight leash because their sole mission is to lend to small utilities. They are not distracted by such things as stock buybacks and other "shareholder value" enhancing maneuvers that often pile on debt and are a bane to bondholders. The reason: It's a private, not-for-profit organization.

Because of the shellacking the financials have taken, National Rural bonds are not richly priced. Buy the National Rural Utilities 7.25s due Mar. 1, 2012. They're rated a by Standard & Poor's. Priced at 102.25, these noncallable, taxable bonds yield 6.44%, or 5.32 percentage points more than three-year Treasurys.

My next surprise issuer is Xerox, which a decade ago was overloaded with debt and at death's door. Chief Executive Anne Mulcahy arrived in 2001, redefining the company from a copier maker into a document management and services company. Buy the Xerox 6.875s due Aug. 15, 2011. This $750 million issue is large and liquid. Priced at 99.75, the BBB bonds yield 7%, more than compensating you for the default risk.

If you are risk averse, buy one of the new bank bonds guaranteed by the Federal Deposit Insurance Corp. These bonds are aimed at reducing banks' funding costs and thawing frozen credit markets. They're senior (albeit unsecured) debt whose maturity is three years or less. (The guarantee ends on June 30, 2012.) Many banks offer this low-yielding short-term paper, including Bank of America, Goldman Sachs, GE and JPMorgan Chase.

But don't necessarily buy the biggest names. You can pick up an extra five or ten basis points (hundredths of a percentage point of yield) from regional bank bonds.

My advice is to buy newly issued bonds at par, but if you miss that opportunity go for the highly liquid AAA KeyBank FDIC guaranteed 3.2s due June 15, 2012. At a recent 103.48, these bonds are priced to yield 2.14%. A simple, illiquid FDIC-insured certificate of deposit maturing in mid-2012 yields 3%.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.