Bonds look like the buy of the year. But don’t be too hasty...

Are corporate bonds as cheap as they look? Yields are certainly high enough, says James Ferguson, but it’s early days yet.

Are corporate bonds (CBs) as cheap as they look? Yields are certainly high enough. US active investment-grade five-year CBs (the red line on the chart), which means rated BBB or above, are yielding 7.35%. Junk bond yields (black line) are at a stratospheric 22.7%. Considering that coupons are fixed and bond holders rank ahead of all equity if a firm goes bust, these yields look great value compared to the 3.3% dividend yield and prospective 8.5% earnings yield (which is bound to disappoint) that the S&P 500 is offering.

Why is this happening? According to the FT, "assets everywhere are being dumped in favour of cash... corporate bonds are no longer that attractive as collateral for funding because counterparts are demanding more onerous terms in exchange for lending out cash in return." And the revelation that Bernard Madoff's funds, fraudulently valued at $50bn, could be worth just $300m, could lead to further forced selling of CB funds. But once this abnormal sell-off is complete, could corporate bonds offer the year's best investment opportunity?

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James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.