2013 Bond Market Forecast: Where To Find The Best Yields (LQD, PCY, EMB, ELD, COP, VZ, T)

Money Morning Staff: The reality for the 2013 bond market in the United States is that interest rates are forecast to remain low throughout the year and continuing until 2015. The Federal Reserve has made this clear – and that is not good news for Treasuries and investment-grade corporate bonds.

In the case of corporate bonds, issuers have been loving the low interest rate environment gifted to them by Ben Bernanke. Issuing commercial paper is cheap these days; again, good for the issuer, not investors.

That means the question becomes why would investors want to own the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA:LQD), the largest investment-grade corporate bond ETF? LQD has a trailing 12-month yield of less 3.9%.

By comparison, income investors could grab 70 basis points of added yield by owning individual companies found among LQD’s holdings, like the common stock of ConocoPhillips (NYSE:COP) or Verizon Communications Inc. (NYSE:VZ). Also in LQD are shares of AT&T Inc. (NYSE:T), which yield 5.1%.

Of course, higher yields and superior income are available with junk bonds, an asset class that is most easily tapped through ETFs.

However, U.S.-focused junk bond funds come with their own set of issues investors need to consider. Namely, the time to have bought these funds has come and gone. Chasing yield and capital appreciation in high-yield bonds at this point is risky business. Outflows from the corresponding ETFs indicate the smart money is taking their profits and moving on.

Luckily, there are credible alternatives to U.S. corporates and Treasuries for income investors looking to fill out the bond portions of their portfolios.

Finding those alternatives is not hard at all, it is just a matter of leaving the U.S.

2013 Bond Market Forecast: Where to Turn

All that needs to be done is consider emerging markets bonds, both sovereigns and corporates.

A few years ago, these would have been considered highly risky asset classes by Western investors.

That is no longer the case, and the reasons are easy to explain.

For starters, many developing nations have stronger government balance sheets than do their developed market peers. Remember when we mentioned the Philippines, as one example, could be headed for a debt-free future?

Along with improving credit ratings throughout the emerging world, these are obvious catalysts to explain the robust inflows into emerging markets bond ETFs, such as the iShares JPMorgan USD Emerging Markets Bond Fund (NYSEARCA:EMB) and the PowerShares Emerging Markets Sovereign Debt Portfolio (NYSEARCA:PCY).

EMB has a trailing 12-month yield of 4.3%. PCY, the smaller of the two, is even better at 4.7%. When accounting for paid dividends, PCY and EMB are up 18.5% and 14.8%, respectively.

Speaking of dividends, these two ETFs provide monthly income and do so with holdings that are heavily investment-grade. Not to mention, EMB and PCY offer better performance and less volatility than some U.S.-focused junk bond ETFs.

Dollars Don’t Always Make Sense

Since January 2010, there have been only two months of net outflows from emerging markets bond funds, according to iShares.

Interestingly, not all of the cash has been going to the supposedly more conservative dollar-denominated funds such as the aforementioned EMB and PCY.

A nifty attribute about emerging markets bonds is that growth is being seen among issues denominated in local currencies. That provides U.S. investors with an avenue to generate income and gain capital appreciation all while hedging against potential downside for the U.S. dollar.

There are several bond market options to consider on this front, but two of the better bets have proven to be the passively managed Market Vectors Emerging Markets Local Currency Bond ETF (NYSEARCA:EMLC) and the actively managed WisdomTree Emerging Markets Local Debt Fund (NYSEARCA:ELD).

EMLC has added over $150 million in assets in just the past six months. That ETF spreads about half of its weight between Brazil, Poland, South Africa, Russia and Malaysia. Nearly 61% of the fund’s constituents are rated investment-grade. The trailing 12-month yield is 4.4% and once again, investors get the benefit of a monthly payout.

ELD also offers a monthly dividend and roughly three-quarters of its holdings are rated investment grade. Forty-one percent of that ETF’s weight lies in Brazil, Mexico, Malaysia and Indonesia. Investors do not need to own both ELD and EMLC at the same time, but ELD is the preferred option for the extremely cautious.

Translation: Since the fund is actively managed, it can quickly move out of a country where an unforeseen negative credit event occurs. Fortunately, when it comes to emerging market bonds, that type of event is far less likely today than it was a decade ago.

Written By The Money Morning Staff

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