A Good Year for Income Investors?

01/23/2008 12:00 am EST

Focus: MARKETS

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, editor of the Forbes/Lehmann Income Securities Investor, says 2008 should be good for income investors-if they stay away from risky, low-quality issues.

We begin the new year with numerous concerns about the outlook for 2008. We also begin with a residue of fallout from the subprime mess which has left income securities yields out of sync with the overall economic picture.

This year faces prospects of a recession in which interest rates, with the exception of below investment grade issues, can be expected to fall, thereby promising capital gains as well.

The adverse events of 2007 should not be viewed based on where your investments were at the beginning of that year, but rather what's likely from today forward. It's an old story: investors see a glass that is half empty because they once saw it as full. However, those who can detach reason from their emotions will see that the turmoil of 2007 has created buying opportunities.

In fixed income, the norm is for a security to trade near its par value, i.e. for the glass always to be full. When market forces such as we saw in 2007 drive prices of investment grade issues to a yield of 8% from a coupon rate of 6%, the price will drop from its usual $25 to something below $20. This is a buying opportunity, not reason to fear that it may go even lower.

To see where the opportunities lie, note the changes in yield spreads for corporate bonds and how they have widened between year-ends 2006 and 2007. Even more important, note how much more the yields widened for preferred issues versus for bonds. The greater increase in the preferred spreads over the increase in bond spreads is that preferreds are held mainly by individuals and smaller institutions. These investors are more easily spooked by market volatility, so even a relatively small rush for the exit door causes severe declines because the preferred market is much less liquid than the bond market [as a whole].

In your search for opportunity, however, don't be tempted by the compelling returns offered for single-B and CCC bonds and preferreds with the exception of special situations such as Ford and GM. Although a spread of 879 basis points over ten-year Treasuries for CCC bonds looks like it has a lot of down side protection built in, this spread can easily go to 1200 basis points if we do have a recession and defaults start to accelerate.

Projections of interest rates have ten-year US Treasuries going to 3.5% or lower by year end. (They actually dropped below that level on Tuesday-Editor.) Some analysts are therefore recommending the purchase of municipal bonds. While this is good logic, I suggest waiting until a pending Supreme Court opinion on the rights of states to give preference to interest income earned on in-state muni issues is announced. Bonds from states like New York, New Jersey, and California could face price declines, as would their single-state municipal bond funds.

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