Corporate Bonds: Income May Drive Potential Returns in 2017

Key Points

  • We believe corporate fixed income investments still have room to outperform Treasury securities in 2017, although total returns may not be as strong as in 2016.
  • With yields potentially set to rise, income payments—rather than price appreciation—likely will be a bigger factor in total returns in 2017.
  • We are neutral on both investment-grade and high-yield corporate bonds, and we now have a less cautious stance on high yield. Investments with floating coupon rates may help investors earn higher yields when short-term interest rates rise, while also offering relative price stability.

Corporate fixed income investments have performed admirably in 2016, with most posting positive total returns and outperforming U.S. Treasuries. What’s in store for 2017? Total returns may not be as strong, but we still see room for outperformance relative to Treasuries.

2016 total returns have been relatively strong

Taking on credit risk has worked relatively well in 2016. Year to date, most credit-related sectors have posted positive total returns and have outperformed U.S. Treasuries.1 High-yield corporate bonds have been the best-performing fixed income asset class of any we track, with the Bloomberg Barclays U.S. Corporate High-Yield Bond Index posting a year-to-date total return of more than 15%. Meanwhile, preferred securities—investments with long maturities or no maturities at all—have outperformed U.S. Treasuries even as long-term bond yields have risen sharply over the past few months.

However, we see a greater risk of yields rising for many corporate investments, rather than falling. Because bond prices and yields move in opposite directions, it’s likely that income payments will make up much of the potential total return in 2017, rather than price appreciation.

Credit has performed well so far in 2016

Source: Bloomberg. Indexes represented are the Bloomberg Barclays U.S. Treasury Index, Bloomberg Barclays U.S. Corporate Bond Index, Bloomberg Barclays U.S. Corporate High-Yield Bond Index, BofA Merrill Lynch Fixed Rate Preferred Securities Index, and the S&P/LSTA Leveraged Loan Total Return Index. Total returns from 12/31/2015 through 12/5/2016. Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

Less cautious on high-yield bonds, but valuations still matter

We are adjusting our stance on high-yield corporate bonds. Although we are still neutral on high yield, we are removing our cautious undertone. We don’t believe that valuations warrant an overweight position, but we see less risk of a significant selloff in the high-yield market. In other words, if you’ve avoided high-yield bonds because of a risk of a sharp correction, we think that risk has lessened.

Overall, the potential for more expansive fiscal policies due to the new presidential administration should be a positive for U.S. corporations, as revenues and profit growth may begin to accelerate. While concrete details have yet to emerge, proposals to lower the corporate tax rate or to enact a repatriation tax holiday should also serve as a support for U.S. corporations.

Not to be overlooked is the stabilization in commodity prices, as energy issuers make up over 14% of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index. After dropping to roughly $26 per barrel this past February, the price of crude oil has hovered between $40 and $50 per barrel since mid-April. The recent OPEC deal to cut production has pushed the price above $50—its highest level since July 2015. This has a positive effect on corporate defaults; according to S&P, the trailing 12-month speculative grade default rate dropped to 4.7% in October, down from 5% the prior month, which marked the first time in 26 months that the default rate had dropped. The default rate rose modestly to 4.8% in November, but we view that slowing of the upward trend to be a positive for the high-yield bond market.

But valuations do matter, and the yield advantage that high-yield corporate bonds offer over U.S. Treasuries isn’t very attractive today. That’s why we still prefer a neutral, rather than overweight, stance.

One way to evaluate corporate bonds is the credit spread, or yield spread, which is the difference between a corporate bond’s yield and that of a U.S. Treasury security with a comparable maturity. The average option-adjusted spread of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index has dropped to 4.5%, its lowest reading since June 2015.2 Since the movement in yield spreads affects the yield of a bond, a drop in spread can cause the price of a corporate bond to rise relative to U.S. Treasuries, since bond prices and yields move in opposite directions.

While we think the supporting factors mentioned above may prevent spreads from widening sharply, we also see less room for spreads to narrow much further. As such, we think most of the return from high-yield corporate bonds in 2017 will be from income payments, not from price appreciation. While that may seem attractive given the 6.5% average coupon rate of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index, high-yield bonds are still very volatile in nature.

Spreads have retreated from their 2016 highs

Source: Bloomberg. Bloomberg Barclays U.S. Corporate High-Yield Bond Index, using daily data as of 12/2/2016.

Neutral on investment-grade corporates, but stick with short- and intermediate-term maturities

Our outlook on investment-grade corporate bonds is also neutral. Credit spreads are below historical norms, but are still above post-crisis lows. With positive growth and still easy monetary policies globally, we think the relatively higher yields they offer can lead to modest outperformance relative to U.S. Treasuries, but the risk of rising Treasury yields means prices may fall.

Investment-grade corporate bonds tend to have longer maturities than high-yield corporate bonds. The average duration of the Bloomberg Barclays U.S. Corporate Bond Index is 7.3 years, compared with 4.2 for the Bloomberg Barclays U.S. Corporate High-Yield Bond Index.3 Given the backdrop for modestly higher Treasury yields, we prefer investment-grade corporate bonds with short- and intermediate-term maturities, given their lower interest rate sensitivity relative to long-term bonds.

Worried about rising rates? Consider floating-rate investments

A floating-rate security is an investment without a fixed coupon rate. Rather, the coupons are usually based on a benchmark interest rate, like the three-month London Interbank Offered Rate (LIBOR), plus a spread. For example, the coupon may be quoted as three-month LIBOR plus 100 basis points, or 1%. If LIBOR were 1%, the coupon rate would be 2%. There are many different types of floating-rate investments, but this discussion will focus on investment-grade floaters and bank loans.

Investment-grade corporate floaters offer two key benefits: Coupon payments can adjust quickly when short-term rates rise, and prices tend to be relatively stable. With expectations that the Federal Reserve will raise short-term rates a few more times in 2017, the low interest rate sensitivity of floaters can help stabilize the value of a diversified fixed income portfolio.

Investment grade floater prices have been stable despite the rise in Treasury yields

Source: Barclays. Bloomberg Barclays U.S. Treasury 1-5 Year Bond Index, Bloomberg Barclays U.S. Corporate 1-5 Year Bond Index and Bloomberg Barclays U.S. Floating-Rate Note Index. Price changes on the right side of the chart represent the price return of each respective index from 11/8/2016 through 12/5/2016. Past performance is no guarantee of future results.

Floaters do come with unique risks. Because they are issued by corporations, they carry credit risk—that is, the possibility that the issuer will default on debt payments or even principal repayment—and there can be periods of volatility if economic conditions deteriorate. Most corporate floaters are issued by financial institutions, increasing sector concentration risk; 55% of the Bloomberg Barclays U.S. Floating-Rate Note Index is composed of bonds issued by financial institutions.

Bank loans are another type of floating-rate investment, but they are very different from investment-grade corporate floaters. Bank loans are private investments that are generally held by funds or by large institutional investors, and they carry sub-investment-grade ratings. They are also backed by a pledge of the issuer’s assets, like inventories or receivables.

Like investment-grade floaters, bank loan coupon rates comprise a reference rate, like three-month LIBOR, plus a spread. Bank loan spreads tend to be significantly higher than investment-grade floaters, due to their increased risk. Most bank loans have what’s known as a LIBOR floor, which means that regardless of how low LIBOR goes, the coupon rate would be based on the higher of the floor or actual level of three-month LIBOR. That mattered when LIBOR rates were really low, but they have risen sharply over the past few months. Most bank loans have a floor of 1% or below, so with three-month LIBOR currently at 0.95%, the presence of a floor likely won’t matter much once LIBOR gets above 1%. If the Fed hikes rates a few more times in 2017, as we expect, then the coupon rates on bank loans should reset higher accordingly.

There’s not much room for bank loan prices to rise, however. Historically, bank loan prices don’t rise much higher than their $100 par value, and the average price of the S&P/LSTA Leveraged Loan Index is currently $97.3. Considering the average price has risen roughly 6.5% so far in 2016, we think it would be difficult to replicate the strong year-to-date total return that bank loans have generated, as returns in 2017 are more likely to be driven by income return and less by price appreciation.

With prices near par, income payments will likely drive total returns in 2017

Source: Bloomberg. S&P/LSTA Leveraged Loan Index, using daily data as of 12/5/2016.

Preferred securities: volatility and potential price declines ahead

Preferred securities were hit hard by the sharp rise in Treasury yields in the second half of 2016. With preferred securities having long maturities or no maturity date at all, the more than one percentage point rise in the 10-year Treasury yield since early July has pushed preferred yields up and prices down. Since its 2016 peak on August 8, the average price of the BofA Merrill Lynch Fixed Rate Preferred Securities Index has fallen 7.6% to $99.4, its lowest reading since March 2014.4 But preferred securities offer high coupons that can help offset price declines. Year to date, the total return of the index is still positive—and higher than the return of U.S. Treasuries—as mentioned above.

We do see risk to preferred prices falling further, as future Fed hikes, along with potentially stronger growth and inflation, may push long-term Treasury yields higher. But we don’t think any rise will be as sharp as what we witnessed in the second half of 2016. We think it’s possible that the 10-year Treasury yield rises to the 2.5% to 3% range in 2017, which would only represent a slight rise from current levels and may only lead to a modest drop in preferred securities’ prices.

While we think preferred securities are still appropriate for long-term investors looking for higher income, some caution is warranted over shorter time horizons. Any potential stock market volatility could spill over to the preferred market, and the long durations of most preferred securities means their prices can drop sharply if long-term Treasury yields drift higher. Most importantly, preferred securities should always be considered long-term investments and should be considered a complement to, not a substitute for, an investor’s core fixed income holdings.

What to do now

Stick with your long-term allocations to the credit-related parts of the market, but wait for better entry points to move to an overweight position. While the potential for stronger growth and lower tax rates may be a boon for corporations, we see less room for prices to rise given the current valuations.

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.

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