Charles Schwab says Corporate Bonds: On a Roll This Year
By Charles Schwab
Apr 03,2014 12:05 PM
Most corporate credit-related sectors of the U.S. bond market posted positive total returns in the first quarter, and we expect that trend to continue.
We still favor investment-grade corporate bonds relative to Treasuries, due to the yield advantage they offer.
At a yield of roughly 5%, we think the risks outweigh the rewards in the sub-investment-grade corporate bond market.
First quarter 2014 performance review
After a rough 2013, corporate bonds had a good first quarter. Most corporate credit-related sectors of the U.S. bond market posted positive total returns in the first three months of the year. Lower Treasury yields coupled with declining credit spreads helped push prices higher.
A credit spread, or yield spread, is the additional yield a corporate security offers above a Treasury with a comparable maturity. It can be thought of as compensation for the additional risks involved with corporate investments, such as the risk of default.
Investment-grade bonds, as measured by the Barclays U.S. Corporate Bond Index, generated a first quarter total return of 2.94%. That was a welcome change from the negative total return the sector posted in 2013. The Barclays U.S. Corporate High Yield Bond Index, an index of sub-investment-grade bonds, came in slightly ahead of its higher-rated counterparts with a total return of 2.98%. The Barclays U.S. High Yield Loans Index also generated a positive total return of 1.12%.
Credit-related sectors of the bond market posted positive total returns in the first quarter of 2014
Source: Barclays, as of March 31, 2014. Indices represented are the Barclays U.S. Corporate High Yield Bond Index, Barclays U.S. Corporate Bond Index, Barclays U.S. Aggregate Bond Index, and the Barclays U.S. High Yield Loans Index. Returns assume reinvestment of interest and capital gains. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
Corporate fundamentals are strong for now
Corporate balance sheets remain strong, on average, but we think the tide could be turning. U.S. corporations have been boosting their cash balances, and liquidity remains high. In fact, the U.S. nonfinancial corporations’ liquid assets/short-term liabilities ratio is at an all-time high.1
Corporate liquidity is at an all-time high
Source: Federal Reserve Board, statistical release Z.1, Flow of Funds Accounts of the United States: Flow of Funds, Balance Sheets, and Integrated Macroeconomic Accounts, Fourth Quarter 2013.
The rise in cash balances has also come with an increase in bond issuance. Many firms have taken advantage of low interest rates to retire their shorter-term, higher coupon debt by issuing bonds with longer maturities and lower coupons. While this does have positive attributes—mainly, lower interest expenses and lower refinancing risk—it can lead to problems down the road.
While sub-investment-grade issuers have pushed back the year in which a large amount of their bonds come due, also called the “maturity wall,” refinancing risk in that year has increased. Out of the $737 billion in sub-investment-grade debt with maturities of five years or less, 71% matures in 2017 and 2018, with maturities peaking in 2018 at $317 billion, according to Moody’s Investors Service.2 Issuers will need to retire these bonds with cash on hand, or refinance them through the capital markets, or some combination of the two. And if rates rise over the next few years, it means investors will be paying higher rates on a growing debt base. This could be a burden for many issuers.
Investment-grade corporate bonds: Still favorable, but upside is limited
We still favor investment-grade corporate bonds relative to Treasuries, due to the yield advantage they offer. However, that advantage has been declining, and the average option-adjusted spread of the Barclays U.S. Corporate Bond Index is well below its 20-year average. In fact, it’s at its lowest since July 2007, before the financial crisis.3 So while you’ll still get paid a premium for a corporate bond’s additional risks (compared to a U.S. Treasury), that premium is near a seven-year low.
Spreads at these low levels don’t necessarily mean a reversal is imminent, however. There have been periods of time when spreads have remained very low, and in a very tight range, for a sustained period of time. We don’t expect spreads to touch their all-time lows, as the risks from 2008/2009 are still fresh in investors’ minds and economic growth remains below potential for the time being. However, we see few risks that would lead to significant sell-off relative to Treasuries.
Although we’re unlikely to experience a repeat of the almost double-digit returns investment-grade corporate bonds have averaged since 2009, we think it’s reasonable to expect positive total returns in 2014.
Credit spreads can remain low for extended periods
Source: Barclays. Using monthly data as of March 31, 2014, 2013. Barclays U.S. Corporate Bond Index. Option-adjusted spread is a method used in calculating the relative value of a fixed income security containing an embedded option, such as the borrower’s option to prepay the loan.
We still prefer intermediate-term investment-grade corporate bonds, but we think the time to add a little duration to an investor’s fixed income portfolio could be approaching if yields move up slightly from their current levels. While the yields offered on intermediate-term investment-grade corporate bonds have risen lately and become more attractive, we think they’re vulnerable to a further rise in interest rates as the Fed changes its guidance.
We still like this slice of the market, but it may make sense to look at longer-term maturities—such as those around 10 years in maturity—as interest rates rise.
Sub-investment-grade corporate bonds: Remain cautious
As in the investment-grade market, the credit spreads on sub-investment-grade bonds have been on a declining trend. The average option-adjusted spread of the Barclays U.S. Corporate High Yield Bond Index was 3.58% as of March 31—the lowest it’s been since July 2007. In other words, the additional compensation sub-investment-grade bond investors are getting is the lowest in almost 7 years.
But it’s not necessarily the low spread—still more than 100 basis points above its all-time low—that has us nervous. It’s the level of yield. The average yield-to-worst of the Barclays U.S. Corporate High Yield Bond Index was 5.23% on March 31, compared to its all-time low of 4.95% in May 2013. We think it will be difficult for yields to go much lower from here, which means price appreciation may be limited. Yield-to-worst is the lowest potential yield that can be received, short of default.
We think the risk of spreads rising significantly—meaning bond prices would fall relative to Treasuries—over the short-term is fairly limited. That’s because liquidity remains high and sub-investment-grade issuers have been able to successfully refinance many of their short-term maturities. But at a yield of roughly 5%, we think the risks outweigh the rewards in the sub-investment-grade corporate bond market. Investors with a more conservative or moderate risk tolerance who have been reaching for yield in the sub-investment-grade market might consider moving up in credit quality.
Bank loans: Still too early
Bank loans continue to generate investor interest, with mutual fund flows into bank loans dwarfing the flows into other domestic fixed income asset classes. Through the 12 months ending February 2014, bank loans saw more than $58 billion in net inflows.4 Over the same period, short-term bond funds ranked second, but with just $21 billion in net inflows.
Bank loans are a type of corporate debt that 1) has floating coupon rates, 2) is secured by a pledge of the issuer’s assets, and 3) has sub-investment-grade ratings. Investors often pay attention to the first two characteristics and ignore the third.
The coupons on bank loans are usually tied to the three-month London Interbank Offered Rate (LIBOR). LIBOR has a high correlation with the Fed funds rate.5 Since that’s the case, the coupons on bank loans are unlikely to rise until the Fed funds rate increases, which we think won’t happen until sometime in 2015. Given that, investors who have been moving into bank loans to take advantage of higher rates are likely a bit early.
Investors also tend to applaud the “secured” status of bank loans, while ignoring the fact that they carry sub-investment-grade ratings. A bank loan is “secured” in that it is backed by a pledge of the issuer’s assets, like inventories, for example. Despite the pledge of assets, though, these investments still carry sub-investment-grade ratings.
While a pledge of assets may help an investor recover more in a default situation, that doesn’t necessarily make the issuer less likely to default. In other words, just because a bank loan is secured doesn’t mean it won’t default. In fact, over the past 12 months, U.S. bank loans have actually had a higher default rate than sub-investment-grade bonds.6
Bank loans are an aggressive investment, just like sub-investment-grade bonds. While a small allocation within an investors’ fixed income portfolio may make sense, they should never be considered a “core” holding for conservative or moderate investors.
I hope this enhanced your understanding of fixed income. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts.
1. Federal Reserve Board, statistical release Z.1, Flow of Funds Accounts of the United States: Flow of Funds, Balance Sheets, and Integrated Macroeconomic Accounts, Fourth Quarter 2013.
2. Moody’s Investors Services, “Maturity Wall Moves Out to 2018, Easing Risk from Higher Interest Rates,” February 4, 2014
3. Option-adjusted spread is a method used in calculating the relative value of a fixed income security containing an embedded option, such as the borrower’s option to prepay the loan.
4. Data from Morningstar, Inc, as of February 28, 2014
5. Correlation is a statistical measure of how two investments move in relation to each other.
6. Moody’s Investors Services, “February Default Report,” March 7, 2014
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Barclays U.S. Corporate Bond Index covers the USD-denominated investment grade, fixed-rate, taxable, corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P, and Fitch. This index is part of the U.S. Aggregate.
Barclays U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
Barclays U.S. High Yield Loan Index provides total return metrics of the universe of USD-denominated syndicated term loans.
Barclays U.S. Aggregate Bond Index covers the USD-denominated, investment-grade, fixed-rate and taxable areas of the bond market.
London Interbank Offered Rate (LIBOR) is the average interest rate estimated by leading banks in the United Kingdom that they would be charged if borrowing from other banks.
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