Now that many higher quality corporate bonds are finally offering compelling yields, income seeking investors are finally getting a break. Notwithstanding a recent uptick in prices, financial markets have generally been veering towards risk aversion for the past year or so and that’s providing some intriguing income opportunities.

I have written in this column before about “credit spreads”, or the extra yield available from bonds not directly backed by large governments such as the United States. With investors growing increasingly cautious, companies looking to raise capital have been forced to offer higher rates of interest in order to float new deals.

The financial sector dominates the public debt markets and this industry has seen especially large spread widening. Recently, Wells Fargo, a solid “A” rated bank, came to market with a five-year bond offering a yield 1.25 per cent higher than a comparable US Treasury note. A year ago, the same bond would likely have provided only about half the spread.

Of course, bonds issued by companies rated less than “A” are offering even higher yields and some of these make sense within a diversified portfolio, at least to a point. Much lower rated issues usually carry very specific company risks which need to be considered.

Overall, we like solid US bank bonds and “preferred” issues best in this environment. Preferreds, or “prefs” as we sometimes call them, are really fixed-income investments. They are also referred to as ‘hybrids’ because, even though income payments are typically fixed at a specified level, distributions usually happen quarterly like most common stocks. Also, prefs tend to be rated lower than an issuer’s senior debt but carry a higher claim on assets than equity from the same company.

European bank debt and preferred securities have undergone a particularly severe beating this year and deserve some attention at these lower prices (meaning higher yields). However, credit analysis is crucial in this volatile sector and we could see some further problems. Not all banks are created equal!

Notably, Europe’s banks have not been as aggressive in raising capital as their American counterparts even though progress has been made on both sides of the Atlantic. By one popular measure, the average capitalisation ratio of US banks is 6.6 per cent versus 4.5 per cent in Europe. Furthermore, European banks have a spotty track record of making good loans, often finding themselves in the wrong place at the wrong time.

Earlier this year, European banks stocks fell to their lowest levels in four years on fears the lenders were too exposed to the beleaguered commodities sector and flagging emerging markets. Bank debt, preferred shares and common stock all declined in sympathy with commodity prices in January and February, although they have rebounded somewhat since. Prefs backed by Germany’s largest bank and former financial stalwart, Deutsche Bank have been knocked down to the point of offering yields of up to eight per cent as investors were spooked by the uncertainty of its ongoing restructuring programme and mounting regulatory fines.

On the plus side, European pref shares are attractive to offshore investors from an income standpoint as they generally do not withhold taxes at source unlike stock dividends. The high yields offered by European preferred shares and subordinated debt are enticing but investors need to be careful.

Contingent convertible bonds, or CoCos as they are commonly known are one type of security offering some of the highest yields, but requiring the most due diligence. CoCos are not exactly common stock, but not exactly bonds or even prefs. These oddball securities were created several years ago when European banks were mandated to increase their capital positions under new regulatory rules designed to shore up overleveraged balance sheets. The Basel III rules established by the Europe’s regulators now require banks to maintain a specified level of capital as a precaution in the event of another economic shock to the Euro zone.

CoCos are generally considered “tier one” securities which means they count towards a basic capitalisation measure under the new capital requirements. However, in order to get investors interested in European bank equity after the tumultuous 2012 credit crisis, these entities had to offer a very high income payout; but these yields come with the downside risk of potentially being forced to convert into straight common stock or even being wiped out in a worst-case scenario. A capital event can be triggered either through poor stewardship, large write-offs from loan losses or regulatory fines.

From the outset, I did not like the CoCo structure as it appeared to lure investors into an almost equity-like security through the promise of higher-than-market yields (see my article “Not Loco for CoCos”, December 14, 2014). As it has turned out, a basket of Coco bonds is down about 7 per cent since the article was published, not exactly a winning proposition despite the high coupons.

It doesn’t take much to touch off a selling panic these days and during these times of “risk-off” behaviour, investors will pay almost anything for the perceived safety of government bonds while dumping those securities deemed to have any degree of economic or financial risk.

Amid these periodic sell-offs in credit-related securities, a properly diversified fixed-income portfolio has the potential to give investors some of the yield which has previously been elusive. Now is a good time to consider a well managed credit fund which employs strong security selection backed up with credit research. A savvy bond manager can find both value and yield in this environment.

• Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.