Schwab Bond Insights: Investment-Grade Corporates, California Drought and Munis, Premium Bonds

Key Points

  • Falling Treasury yields have helped push the total return on the Barclays U.S. Corporate Bond Index higher than most other types of fixed-income indexes this year. 
  • California's water shortage has prompted usage restrictions, potentially hurting revenue at water utilities.
  • You pay more for premium bonds than their par value. We explain why this might make sense.

Defying expectations, 10-year Treasury yields have fallen this year to below 2.5% after ending 2013 above 3%.

Driven by the drop in yields and the corresponding rise in prices, almost all U.S. fixed income asset classes have posted positive year-to-date total returns. Long-duration investments have turned in the best performance, and investment-grade corporate bonds have been particular standouts.

Depending on what your portfolio looks like, the yield declines have been either a good thing or a bad thing. The lower yields pose a problem for investors seeking higher yields. However, they have been a boon for investors holding bonds, since bond prices, which move in the opposite direction of yields, have risen.

While we think long-term yields will ultimately trend higher, we expect that to take a while. In the meantime, we see some factors that can prevent long-term Treasuries from moving significantly higher anytime soon. Geopolitical risks will likely keep demand for U.S. Treasuries high, as should the yield advantage they offer relative to other highly rated developed market government bonds.

However, because short- and intermediate-term Treasury yields are more heavily influenced by FOMC policies, they are at a higher risk of rising sooner. The Fed is still on pace to end its bond-buying program in the fourth quarter, and even though some expect it to come earlier, we still view a mid-2015 interest rate hike as likely. Therefore, we expect the yield curve to continue flattening as shorter-term rates climb and longer-term rates remain relatively steady.

We continue to recommend investors focus on intermediate maturities and wait for a better entry point to add duration. Duration measures how sensitive a bond is to interest-rate risk. We think investors may want to begin adding some fixed income investments with higher durations when the 10-year Treasury yield gets closer to 3%.

Strong returns on investment-grade corporates

After a disappointing 2013, investment-grade corporate bonds are once again delivering positive returns, thanks mainly to price gains linked to falling Treasury yields. And although yields on investment-grade corporate bonds are now near all-time lows, we still think they look attractive relative to Treasuries and make sense for investors looking to generate income without incurring too much risk.

Positive total returns

The Barclays U.S. Corporate Bond Index has generated a total return of 6.6% this year—a nice improvement from its 1.5% drop in 2013. In fact, investment-grade corporate bonds have performed better than most other types of fixed income investments this year, including sub-investment-grade bonds, as you can see in the chart below.

Investment-grade corporate bonds have posted strong year-to-date total returns

Investment-grade corporate bonds have posted strong year-to-date total returns

Source: Barclays. Year-to-date total returns as of August 25, 2014. Barclays U.S. Aggregate Bond Index, Barclays U.S. Treasury Bond Index, Barclays U.S. Corporate Bond Index, Barclays U.S. Corporate High Yield Bond Index, Barclays U.S. Mortgage-Backed Securities Index, Barclays Global Aggregate ex U.S. Bond 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 indication of future results.

We think the recovery in corporate bond returns mainly reflects a decline in Treasury yields (the yield on the 10-year Treasury was at 2.38% on August 25, down from 3.03% at the end of 2013).

With a few exceptions, investment-grade corporate bond yields have tended to move in tandem with Treasury yields. When bond yields fall, prices rise—and rising prices mean higher total returns.

Although corporate bond yields have fallen, creating a dilemma for income-focused investors, we still think they look more attractive than Treasuries.

How do spreads look?

Because of the increased risks associated with corporate bonds, their yields are higher than those on comparable Treasuries. The difference is known as the credit spread.

The average option-adjusted spread of the Barclays U.S. Corporate Bond Index was 1.01% on August 25,1 below the average of recent decades. Since 1989, when the index started tracking spread data, the average spread has been 1.3%, almost 30 basis points higher than its current level.2

The lower the spread, the smaller the yield premium investors receive relative to what they would get from lower-risk Treasuries. Because spreads are below their historical average, one might get the impression that corporate bonds are overvalued. However, we still think they make sense.

For one thing, the market disruptions of the past 10-15 years have tended to inflate the long-term spread average. If we exclude those periods, spreads generally tend to hover in tight ranges. Looking at the median historical spread for the period can help weed out such distortions.3 Since 1989, the median option-adjusted spread of the Barclays U.S. Corporate Bond Index has been 1.03%, very close to where it is today, which makes investment-grade corporate bond valuations look more appropriate.

Where are spreads headed?

We can review historical data to determine how much time average spreads have spent below their current level of about 1% to gain some sense of their behavior. Based on month-end data, the average option-adjusted spread of the Barclays U.S. Corporate Bond Index has hovered below that level nearly half (47%) the time since 1989.

Investment-grade corporate bond spreads tend to trade in tight ranges

 Investment-grade corporate bond spreads tend to trade in tight ranges

Source: Barclays. Monthly data as of August 25, 2014. 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. When we reference a "credit spread" for a corporate bond index, we are referencing the option-adjusted spread.

Before the last financial crisis, spreads were as low as 0.85% in early 2007, and now we don’t think there’s much room for them to fall from their current level. However, they’ve historically stayed below 1% roughly half the time, and it’s possible they could remain in their current low range for several months, or even years. While this may mean prices aren’t likely to rise much further, we also see less downside risk compared to other fixed-income investments, especially sub-investment-grade bonds.

The average option-adjusted spread on the Barclays U.S. Corporate High-Yield Bond Index is around 3.6%—below its 20-year average of 5.3%—meaning investors are getting less than average compensation for the risks associated with this part of the bond market. We think investors who have been reaching for yield from sub-investment-grade bonds should consider moving up in quality to investment-grade corporate bonds.

What to do now

We believe intermediate-term investment-grade bonds make the most sense right now, especially for investors who have been reaching for yield in the lower-rated segments of the fixed-income market.

Short-term bond yields are still very low and in our view will likely rise as we get closer to the first Federal Reserve interest rate hike, expected sometime next year. And with the 10-year Treasury bond currently offering a yield of 2.38%, we think investors would be better off waiting for more attractive entry points on the long end of the yield curve. We also think investors can consider beginning to add a little duration to their fixed income portfolios when the 10-year Treasury approaches 3%; until then, we prefer intermediate-term bonds.

For investors who hold individual bonds, we think a portfolio that diversifies among various sectors is appropriate.

Spreads for each sector have converged over the past few years

Spreads for each sector have converged over the past few years

Source: Barclays. Monthly data as of August 25, 2014. Data shown represents the Industrials, Utilities, and Financials sub-indices of the Barclays U.S. Corporate Bond Index. 

Investment-grade corporate bonds are usually broken down by three broad sectors: utilities, industrials and financial institutions. Today, the average option-adjusted spreads of each sector are all very similar, meaning it’s difficult to find one sector that offers a significantly higher yield. A Schwab fixed income specialist can help you select bonds that make sense for your portfolio.

Impact of California drought on munis

What impact will California's water shortage have on the municipal bond market? The state's drought, now in its third year, has prompted rationing and redoubled conservation efforts. While those measures could reduce revenue at California water utilities, we don't think they're likely to do much to hurt holders of those utilities' municipal bonds.

In July, the California State Water Resources Control Board adopted measures to curb water usage throughout the state in response to the ongoing drought. We believe these measures won't have a significant impact on the credit quality of water utilities or the state's general obligation (GO) bonds. 

When it comes to water utilities, droughts have a direct impact on two factors: water usage and water supply. 

Water usage

A decline in water usage can lead to a decline in revenues used to pay bonds. In July, Gov. Jerry Brown called for a 20% decrease in statewide water use. However, restrictions vary by local agency, and each utility’s flexibility to address a decline in revenues will vary.

If the drought continues at its currently severe pace, we believe some utilities will attempt to raise rates charged for water usage in an attempt to offset the reductions in water consumption. Under state law, water utilities must file a public notice of proposed rate changes. Objections to these rate changes are typically limited.

However, practically and politically speaking, there may be a limit to how high some utilities can increase their water usage fees. A decline in revenues may affect a utility’s debt service coverage ratio, or the amount of cash flow it generates to meet its annual debt payments.

Most utilities that issue investment-grade rated bonds should have the flexibility and financial reserves to manage drought conditions. However, the prolonged drought may highlight credit weaknesses for lower-rated bonds with lower coverage or bonds issued by utilities with less flexibility or financial reserves.

The table below provides details on several utilities with lower debt service coverage ratios, according to Moody’s. The median debt service coverage ratio for fiscal year 2013 was 2.7x, meaning the cash available to pay debt service was 2.7 times the amount owed. While a low debt service coverage ratio may be an indicator of less financial flexibility, it does not by itself indicate a poor financial situation, as it is one of many metrics used to evaluate the financial position of a municipality.

 

Utilities with lower debt service coverage may have less flexibility

 

Utility

Moody’s adjusted debt service coverage

Fiscal year

Moody’s rating

S&P rating

Sierra Madre (City of) Water Enterprise

0.3x

2012 

Ba1

N/A

Central Basin Municipal District

0.7x

2012

Aa3*

A*

Antelope Valley-East Kern Water Agency

1.0x

2013

A2

A

Kern County Water Agency Improvement District

1.1x

2012

Aa3

A

Redwood City Public Finance Authority, Water Enterprise

1.2x

2012

Aa3

AA-

Contra Costa Water District

1.4x

2013

Aa2

AA+

West Basin Municipal Water District

1.4x

2013

Aa2

AA-

Paradise Irrigation District

1.4x

2012

A1

A+

San Diego County Water Authority

1.5x

2013

Aa2

AA+

Sacramento County Water Agency

1.6x

2013

Aa3

A+

Source: Moody’s, as of January 27, 2014, S&P; ratings are underlying ratings.

Some investment grade-rated water revenue bonds also provide a funded debt service reserve, equal to 100% of the maximum annual debt service payments. This provides an additional cushion in case revenues fall. Refer to a bond’s Official Statement for more detail.

Water supply

This drought may be severe, with the state's major reservoirs only about 40% full,4 but droughts are not new to California. Most water utilities have taken prior steps in an effort to plan for droughts.

Water to the majority of California consumers is delivered through a handful of large water projects. The largest utilities generally have sufficient storage to manage supply. Local agencies that provide retail water supply also store water locally.

The table below shows data from Moody’s on storage capacity for the largest California water utilities.

Largest California water providers generally have sufficient supply

 

Utility

Amount of annual water delivery in storage (years)

Unadjusted debt service coverage

Fiscal year

Moody’s rating

S&P rating

Metropolitan Water District of Southern California

1.7

2.4x

2013

Aa1

AAA

Los Angeles Department of Water and Power*

1.1

2.3x

2013

 

Aa2

AA-

San Diego County Water Authority*

0.5

1.6x

2013

Aa2

AA+

Orange County Water District

1.5

2.2x

2013

Aa1

AAA

Santa Clara Valley Water District

2.1

3.1x

2012

Aa1

AA

San Francisco Public Utility Commission

1.7

2.1x

2013

Aa3

AA-

East Bay Municipal Utility District

2.2

1.7x

2013

Aa1

AAA

Source: Moody’s, S&P.
*Member agency of Metropolitan Water District.

State GO bonds

We believe the drought will have limited impact on California state GO bonds.

California's Department of Water Resources (DWR) helps manage long-term water supply, and the state periodically issues GO bonds to fund statewide water projects. The governor and state are promoting a multibillion-dollar state water bond backed by the state's GO pledge on the November 2014 ballot to support long-term water projects. This is the first state water bond since 2006. The ballot initiative does not, in our view, immediately affect credit quality for the state or water utilities.

Drought conditions may affect agricultural activity, with a more direct impact in certain parts of the state—portions of the Central Valley, for example—with greater agricultural production. Moody’s estimates that farmers may let up to 800,000 acres of agricultural land lie fallow, with losses of an estimated $3.65 billion. 

Agriculture accounts for only 2% of the state’s gross domestic product, so a decline in the agricultural industry should have little to no impact on the state’s overall financial situation.

Bottom line 

For investors concerned about drought conditions or with high exposure to California water utilities, we suggest diversifying by region and reducing exposure to lower-rated (A1/A+ or lower) water utility bonds in areas with significant agricultural activity. A higher rating is still an appropriate measure of financial flexibility. For most investors without issuer concentration, we believe drought conditions on their own likely don’t justify major changes to portfolios.

For further information on the financial condition of a specific utility, investors can review debt service coverage, financial reserves, and other factors by accessing MuniDocs® on Schwab.com or by speaking to a Schwab Bond Specialist. Keep in mind, however, that reported debt service coverage is often delayed.

Understanding premium bonds

With the fall in interest rates this year, many bonds have risen in price and are trading at values above par. Although it may seem like a losing proposition to pay more than $1,000 for a bond that will return just its par value of $1,000 at maturity, we think these "premium bonds" actually have some benefits.

What's a premium bond?

A premium bond is one that's priced above its $1,000 par value. Bond prices are not fixed, as they rise or fall in response to market interest rate changes.

For example, take a bond that was issued earlier this year with a 3% coupon rate. Since most interest rates have fallen this year, a new bond might offer a coupon of 2.5%, giving investors a smaller income stream. To earn the higher income stream offered by the 3% bond, you'll pay a higher price—a premium. Because bond prices and yields move in opposite directions, the higher price would push the yield of the 3% coupon bond down to match the yield of the 2.5% bond.

Conversely, a discount bond has a price below the par value. On the surface, a discount bond might seem like a better deal than a premium bond. Barring default, a discount bond will mature at a higher price than investors initially paid, while the price of a premium bond is destined to fall back to par at maturity.

But a premium bond's higher coupon can offset the price decline as the bond moves back to its par value. That's one of the benefits to premium bonds that we think some investors are overlooking in today's market.

Comparison of premium bonds to par and discount bonds

Comparison of premium bonds to par and discount bonds

Source: Schwab Center for Financial Research. Assumes hypothetical 5-year bonds with semi-annual interest payments.

The benefits of premium bonds

The higher coupon payments from premium bonds can offset the decline in price as it moves towards its par value at maturity. And the higher coupon payments can be helpful if you expect interest rates to rise. Relative to those holding bonds with lower coupons, investors in premium bonds are better able to take advantage of rising interest rates, due to the increased cash flow.

Premium bonds also have lower sensitivity to rising interest rates relative to par and discount bonds, all else being equal. The reason is that a higher coupon generally reduces a bond's duration, a measure of interest rate sensitivity.

One way to think about duration is as a measure of how fast you get your investment back. A higher coupon gives you more money back sooner than a bond with a lower coupon. With most U.S. bond yields still at historically low levels, there's likely more room for yields to rise than to fall. If you're concerned that bond yields will move higher from here, premium bonds can help cushion the blow, as they would fall less in price than a discount bond with a comparable maturity.

Premium priced bonds are less sensitive to changing interest rates

Premium priced bonds are less sensitive to changing interest rates

Source: Schwab Center for Financial Research. Illustration assumes bonds with 10 years to maturity, semiannual payment, similar yields-to-maturities, and an immediate change in interest rates after purchase. For illustrative purposes only. Past performance is no guarantee of future results.

Premium bonds do have risks, just like par or discount bonds

There are still risks with premium bonds, of course. While they are less sensitive to rising interest rates compared to discount bonds, premium bonds are still susceptible to price declines when yields rise. But if yields fall, premium bonds would likely underperform par or discount bonds, since the lower durations of premium bonds would lead to smaller price increases.Also, always look out for any call provisions, which allow the issuer to redeem the bond prior to maturity.

This can be a disadvantage for bonds priced above par. Rather than having the remainder of a premium bond's life to collect its higher coupons, and thus compensate for the higher price paid for the bond, an investor facing a call will see this income stream abruptly cut off. That lowers the return on the bond, and in some cases it can actually lead to a negative total return. For premium bonds that are callable, take a look at the yield-to-call or yield-to-worst, rather than the yield-to-maturity, and always make sure that the yield offered is positive.

What to do now

Don't be afraid of premium bonds. While they may look unappealing on the surface relative to bonds priced at or below par, there are some benefits—including a higher coupon payment and lower interest-rate sensitivity. They can help limit the price declines if rates do rise, and the greater cash flows mean you can take advantage of those higher rates more quickly.

I hope this enhanced your understanding of fixed income markets. 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. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

  • Call Schwab anytime at 877-338-0192.
  • Talk to a Schwab Financial Consultant at your local branch.

   Was this helpful?  

Subscribe:

Subscribe to Emails (clients only) Subscribe via RSS Download the On Investing® iPad® App

Important Disclosures