The Wall Street Journal | Party Goes On in Corporates

Think of the credit markets in 2010 as the midpoint of a wild party stoked with free-flowing money courtesy of Federal Reserve Chairman Ben Bernanke. The festivities look ready to kick into full swing in the year to come and, when they peak, many of the partiers will put on trades they may well regret in the morning.

Credit investors chasing yield didn’t have to reach very far in the past two years because the aftermath of the credit crisis provided a bumper crop of cheap bonds. Rock-bottom interest rates drove investors out of investment-grade bonds—the 2009 market darling—and into high-yield and emerging-market debt over the past 12 months.

Now, however, the low-hanging fruit has been picked clean. And investors stand poised to continue to ratchet up the risk-on trade in the hunt for yield, switching into the lowest rated of “junk” bonds, European debt and, paradoxically, secured loans.

“We want to add more risk to the portfolio. … We think risk outperforms this year,” said Tom O’Reilly, the co-portfolio manager of Neuberger Berman’s $1 billion High Income Bond Fund. Mr. O’Reilly says he will balance out that risk with greater diversification as continued demand for the asset class pushes the average price of junk debt higher.

Supportive fundamentals will keep the bull run in corporate debt going, Mr. O’Reilly added. Credit investors expect default rates to stay in a 2% to 3% range and U.S. gross domestic product to grow between 2.5% to 3% this year as companies that cleaned up their balance sheets continue to generate cash.

The technical underpinnings of the market also look relatively stable. In 2007, the leveraged-loan market was inflated by at least an estimated $120 billion of total return swaps, derivatives that allowed investors to take on $10 of credit risk for every $1 of collateral posted, said Mark Okada, chief investment officer at Highland Capital. Today, it is estimated there are only $40 billion of the swaps outstanding at leverage ratios of 3 to 1.

Ravenous demand pushed the average yield on new bonds rated single-B down to 8% to 8.5% in the last quarter of 2010, compared to around 10% a year earlier and to over 12% during the worst of the credit crunch, according to Standard & Poor’s Leveraged Commentary and Data. The average spread of investment-grade bonds over Treasurys compressed to 1.71% in 2010 through November, down from 2.1% in 2009 and 6.3% in 2008, according to data from Barclays Capital.

Assuming Treasury rates stay low, bond-fund managers will be left with few options to juice performance above the annual interest rates their bonds pay. One straightforward strategy is to increase the weighting of the higher-yielding—and higher-risk—bonds in a portfolio….

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