Corporate Bond Junkies

The guys running the Berwyn Income fund have moved from Treasurys into medium-grade corporates. The tactic worked in the last recession.

George Cipolloni and Edward Killen: buying into a long-awaited blowup.

After three years of hunkering down in cash and Treasurys, Berwyn Income fund comanager George Cipolloni's moment to shine arrived this fall. Hedge fund managers were dumping bonds to raise cash amid a wave of investor redemptions. Cipolloni decided to test the waters with a few low-ball bids. He was shocked when offers started coming back even lower than what he'd proposed.

"It was scary," says Cipolloni, 34. "There seemed to be no floor."

The panic has receded somewhat since Lehman Brothers (nyse: LEHMQ - news - people )' collapse last year, widening spreads on junk bonds to 13.7 percentage points and on investment-grade debt to 4.5 points above ten-year Treasurys. Spreads are off a percentage point or so since then. Still, the yield premium you get from investing in something shakier than a U.S. government IOU is two and a half times what it was at the low point three years ago, and 1.7 times the high point 3.5 years before that.

Since mid-October Cipolloni and comanager Edward Killen, 57, have been pouring tens of millions of dollars into corporate bonds of all stripes--investment grade, junk and convertibles. As they buy risk, they're selling the safety they formerly owned via government-guaranteed securities. A year ago Berwyn Income was 16% in Fannie Mae (nyse: FNM - news - people ), Freddie Mac (nyse: FRE - news - people ) and Treasurys paper. Today it holds none.

"We've been looking for a blowup," explains Killen, who has comanaged the fund for 15 years. "This is our opportunity."

Opportunity, perhaps, but not one the Berwyn managers are willing to paint with too wide a brush. Will junk yields return to their autumn peaks? "No way to know," says Killen. Where are default rates going? "Up," he adds. Even the more loquacious Cipolloni shuns big-picture chatter. "You can nail the default rate and still make a mistake" with a specific security, he says.

The granular approach has worked pretty well for Berwyn Income over the long haul. The $250 million fund returned 5.9% annually in the decade through 2008, versus 2.5% for Lipper's blended best stock and bond index. That performance is net of the modest 0.7% in annual fees.

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Killen and Cipolloni swim against the prevailing currents. At the depths of the last bear market in 2002, when many funds were unloading corporate debt, Berwyn Income started buying junk bonds, real estate investment trusts and convertibles. It returned 9.4% that year, versus a 4.1% loss for the Lipper index.

The two managers say they started fearing a housing bubble in 2006 and shifting out of then popular corporate bonds and into government and quasi-government paper, which was yielding only a hair less. The move hurt returns at first but paid off in spades in 2008.

"Now the pendulum has swung, and the [bond rating] agencies are being too conservative," says Cipolloni.

He and Killen look at some standard yardsticks of creditworthiness, like the ratio of debt to capital and of interest expense to sales. But they claim to not even read Standard & Poor's and Moody's (nyse: MCO - news - people ) credit reports. Instead they comb corporate reports and listen to conference calls to gauge how management has previously dealt with creditors in tough times and whether it seems likely to buy back bonds before equity.

"Some companies don't even mention debt on conference calls," says Cipolloni. "They just want to placate shareholders."

Fearing a deep recession, the Berwyn Income managers are shunning debt from consumer discretionary, commodity and other cyclical businesses. They're also steering clear of distressed bonds trading at triple-C or below. With top stocks, currently 25% of assets, they home in on firms with high dividends and ample means to continue payouts.

They have 7% bonds in Chattem (nasdaq: CHTT - news - people ), maker of Gold Bond medicated powder, with a 9.4% yield to maturity in 2014. They believe Chattem deserves a bb rating, rather than the b assigned it by s&p.

Berwyn also owns debt of credit rater Equifax (nyse: EFX - news - people ). Revenues have fallen along with housing sales, but "people still need credit scores," Cipolloni says. Equifax's 6.3% bonds, due in 2017, yield 10.1%. The Quest Diagnostics (nyse: DGX - news - people ) 5.45s of 2015 are priced at a discount to yield 7.6% to maturity. Quest, notes Cipolloni, hiked profits in the last downturn.

Investors have unloaded bonds issued by household products maker Church & Dwight, pushing the yield on its 6% coupon bonds, maturing in 2012, to 8% (since fallen to 6.6%). The maker of Arm & Hammer baking soda has debt equal to 53% of capital. While there is a lot of goodwill in the capital total, the company has used cash to cut debt in the past and should be able to increase sales this year, as it did in the last two recessions, argues Cipolloni. His fund owns $7.5 million of the bonds.

Last year Berwyn picked up 5.25% convertible bonds due in 2024 from investors fearing that issuer American Equity Investment Life (nyse: AEL - news - people ) was itself holding a lot of toxic financial securities. Berwyn bet otherwise. The price has climbed since, but the convert is still yielding 19.4% to first put in 2011.

Yield of dreams

Though they've rallied recently, these corporate bonds offer yields that more than compensate investors for their risks, according to Berwyn Income's managers.