The Federal Reserve may be tightening monetary policy, but that should not put off investors in corporate bonds because there are still opportunities to get good returns, according to one corporate bond expert.
Steve Shaw, who has two decades of experience in analyzing companies for investment opportunities, is in charge of corporate bond investment recommendations at BondSavvy, an online platform that promotes bond investing among retail investors.
"Over the last year, as rates have risen we continued to see very strong performance in our corporate bonds portfolio, in both high yield and investment grade. Year to date, it's up 7%," Shaw told Real Money.
"It seems that the approach from the Fed is going to be pretty gradual, especially the balance sheet reduction, so I believe corporate bonds will continue to be a good investment."
Major central banks are reducing their stimulus policies across the globe, which has sent yields on sovereign bonds rising. As yields move inversely to prices, bond prices have fallen. This happened to some corporate bonds as well, but Shaw said the more selective investors are, the better opportunities they have.
"If you have to buy the whole market, like an ETF or a mutual fund has to do, then sure, they can face some troubles," Shaw said. "But I am able to pinpoint opportunities because I am able to be very selective when I make my investments."
There are about 2,000 corporate bonds trading daily. While a fund would need to hold about 1,000 of them -- half the market -- because of the sheer amounts it needs to invest, an individual investor can pick just 10, Shaw noted.
Year to date, his portfolio has seen the strongest performance in finance, technology and cable. In the investment-grade universe, a 6.5% bond in investment banking firm Jefferies maturing in 2043 has returned more than 11% year to date, taking into account coupon payments and price increase.
A 4.45% coupon bond in Action Alerts PLUS charity portfolio holding Apple (AAPL) maturing in 2044 has returned more than 7% year to date.
In the high-yield universe of bonds rated below investment grade, a cable company's bond is the year-to-date star performer. A Cablevision bond with a coupon of 5.87% maturing in 2022 has returned more than 10%.
Shaw selects investments by looking at a company's fundamentals. He gave the example of a Toys R Us 10.37% coupon bond maturing in August 2017 in the C ratings universe, which he bought in February last year.
"We generated a 54% annualized return in that bond," Shaw said. "Even though we all know the struggles of the bricks-and-mortar retail sector, there was just an opportunity in that bond. It was maturing in 2017, it was at a significant discount and we were able to get comfortable with it because the company had significant liquidity.
"In terms of interest coverage [a company's earnings divided by interest expense], it wasn't that great, it was only 1.6 times interest coverage, but I knew that the bond was maturing in a year and the company had $1.4 billion of liquidity," he said. "I was comfortable in knowing that I would get paid back."
Individual investors looking to invest in corporate bonds directly rather than through an ETF or mutual fund should compare the yields of companies in similar industries, look at whether there are significant differences between issuers and the reasons behind these differences, and do a "fairly deep dive" on credit analysis, Shaw said.
Retail trading platforms have made it efficient and relatively cheap for individual investors to buy and trade corporate bonds, but the initial amounts needed are still higher than in the case of equities. Bonds are sold in denominations of $1,000, which in theory is the minimum amount a retail investor could invest in a single purchase. In practice, however, dealers generally post minimum order sizes of five bonds, so the minimum amount needed is $5,000.
Still, Shaw said plenty more investors could go into this asset class because this investment opportunity "has been in the shadows" for retail investors for too long.
"Corporate bonds provide a fixed coupon and they pay you back at a set date," he said. "Those are major advantages over bond mutual funds."
