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Corporate bonds seen continuing strong run

NEW YORK (MarketWatch) -- Corporate bonds remain the darling of fixed-income managers and are expected to continue to do well during the rest of the year amid a challenging global economic environment.

As long as there isn't any major blowup -- and investors are comfortable there isn't one on the immediate horizon, companies' strong balance sheets should offer protection against continued uncertainty.

"It's the best house on the block," said Tom Murphy, who heads up investment-grade corporate debt at RiverSource Investments. "It looks like it will be another summer of volatility and people are mentally fatigued and looking for positive signals. But it feels good to have clients invested in the better balance sheets in corporate bonds."

Corporate bonds of all maturities have returned 5.15% so far this year, according to an index compiled by Bank of America Merrill Lynch. That's more than double the return on Treasury bonds, the low-yielding safe-haven beneficiaries, and a better start to the year than in 2011.

That's only slightly better than the Dow Jones Industrial Average (DJIA) , which is up about 5% so far in 2012.

The credit spread -- the spread between company debt yields and Treasury yields -- has narrowed to 2.19 percentage points, or 219 basis points, from 260 basis points six months ago, according to Merrill.

The spread is often considered an indicator of investors' appetite for risk. It widens when investors demand greater compensation for higher risks, and vice versa. The spread has fallen to its lowest level since mid-May.

Having the spread shrink is good for corporate bond holders.

"We'll hear more noise and false starts out of Europe," said RiverSource's Murphy. That could cause periodic flights to the traditional safety of Treasurys. But investors will keep looking elsewhere for higher yields and better returns in areas they don't feel too much risk from the uncertainty surrounding Europe's sovereign-debt and banking crisis.

"Corporate bonds should do fine in that environment," said Murphy, whose firm oversees about $165 billion in fixed-income assets. "I believe spreads will be tighter by the end of the year."

"I'm happy to sit in corporate bonds and be protected by the solid fundamentals," namely the high cash companies are carrying, he said.

Companies have largely become more efficient and lean in recent years, which is positive for bondholders.

This year will be different

That improvement in company balance sheets has been going on for a few years, but macroeconomic worries have still dented corporate bonds. However, this year will be different for a few reasons, said Hans Mikkelsen, global credit strategist at Bank of America Merrill Lynch.

One major change is the European Central Bank's willingness to step in with market-stabilizing measures, moving towards being the lender of last resort in the euro zone, he said. The bank's long-term refinancing operations showed a big change in its involvement in stemming the crisis.

Also, there have been significant capital improvements at U.S. banks, and a further stabilization in the housing market, which will help banks' balance sheets. Financial firms make up a large chunk of the U.S. credit market.

"We're seeing a significant decline in credit spreads because the market is focused on the decline in systemic risks," Mikkelsensaid.

One such risk is whether Greece stays in the euro zone. For the time being, it looks like the country will stay. That will help bonds outperform stocks, which will remain focused on continuing growth risks, he said.

The bottom line is that even after a pretty solid run for corporate bonds, investors still find them the best place to earn better returns while not taking on that much risk related to uncertainties in global growth.

"My advice to anyone who owns Treasurys and doesn't have to?" said Curtis Arledge, chief executive officer at BNY Mellon Investment Management. "Go buy corporates even though it's not sexy."