Schwab Bond Insights: Possible Tapering Pause; Puerto Rico Bonds; Corporate Credit; Why Own Bonds
February 24, 2014
Key PointsThe Schwab Center for Financial Research (SCFR) presents Bond Insights, a bi-weekly analysis of the top stories in today's bond markets. In this issue, we discuss:
- Whether falling inflation and weak economic data will prompt the Federal Reserve to pause its plan to taper its bond purchases;
- What the downgrades on Puerto Rico general obligation bonds to junk from all three major ratings agencies mean;
- Which corporate bond credit ratings we think look attractive for investors;
- Why there are still good reasons to own bonds, even though we expect bond yields to move higher and prices lower.
Weak economic data and falling inflation have raised the question of whether the Federal Reserve will halt—or at least pause—its plan to taper its bond purchases.
We doubt it. In the minutes of the Fed's Open Market Committee meetings over the past year, it was apparent as far back as last spring that several members of the committee had doubts about the usefulness of the policy. The minutes from the April 30, 2013 meeting indicated concern over the risks of financial markets becoming "too buoyant," and by the fall there were references to the "waning benefits of quantitative easing." Moreover, the vote to actually begin tapering was unanimous—a signal there was strong conviction that the time had come to exit from the quantitative easing policy.
Although the Fed has left the door open to halting or even increasing its bond buying if the economy weakens, we think the bar is high for altering the course that's been set. The Fed's statements indicate it plans to reduce its bond buying by $10 billion per meeting, which would mean that QE would end by the fourth quarter of the year.
Yet recent economic indicators have begun to flag significantly. Retail sales, factory orders, exports and job growth have all slowed from the pace of last fall. The Bloomberg Economic Surprise Index, which measures the degree to which economic analysts over- or underestimate the trends in the business cycle, has fallen sharply since mid-December, indicating analysts have gone from overshooting in their forecasts to undershooting.
Economic Surprise Index: September 2013–February 2014
Note: The Bloomberg Economic Surprise Index (ESI) shows the degree to which economic analysts under- or over-estimate the trends in the business cycle. The surprise element is defined as the percentage (or percentage point) difference between analyst forecasts and the published value of economic data releases.
Source: Bloomberg, as of February 14, 2014.
Some portion of the weakness in the data can be attributed to the severe winter weather. However, some indications show the economy was losing momentum before the bad weather hit. Retail sales figures have been revised down for the past three months and even online purchases were weak in January. Overall, the year-over-year pace of retail sales has been slowing since 2012. Similarly, the January unemployment report showed job growth well below expectations for the second consecutive month. Although harsh winter weather was blamed for some of the weakness, construction jobs, which should have been one category most affected by the weather, actually increased while less weather-sensitive jobs in the service sector declined. So, like retail sales, the weather can explain some of the slowdown in job growth, but not all of it.
Inflation is also trending in the wrong direction for the Fed. It has been below the Fed's target of 2% for more than a year, and the trend has been declining. In her recent Congressional testimony, Fed Chairman Janet Yellen indicated inflation was being pulled down by "transitory factors." However, the persistence of the declining trend after five years of very easy monetary policy suggests to us that reversing the trend may be difficult. The Fed's preferred inflation measures—the personal consumption expenditures price index, excluding food and energy—rose by only 1.2% in 2013, the smallest increase since 1955.
All of which leaves the Fed and the bond market in a quandary. The Fed is exiting the bond buying program, but the conditions it has set—improving economic growth and inflation heading toward the 2% target level—are not being met. Meanwhile, bond yields have moved up over the past year in response to the prospects for tapering and improving economic conditions. Real yields (inflation-adjusted using "core" personal consumption expenditures) for 10-year Treasuries are above 1.5%, the highest level since 2010 and nearing the long-term average of 2.0%. If the Fed continues to pull back on its stimulus at a time when the economy is losing momentum, then bond yields may continue to edge lower, contrary to consensus expectations for rising rates this year.
We are not ready to change our view that rates are more likely to rise than fall this year. But we are watching the combination of Fed tapering, falling inflation, and slowing economic growth carefully. If current trends continue, our 3.5% target for 10-year Treasury yields later this year may be too high. Timing the interest rate cycle is never easy, which is why we frequently suggest spreading out the maturities of bonds in a portfolio.
What to do now. In the near term, we expect the trend in bond yields to move sideways until the degree to which winter weather has affected the economy's growth rate is clear. If the current soft patch of economic data does prove to be weather related, however, and we begin to see a stronger trend in economic growth, we think Treasury yields should end the year higher. We continue to suggest that investors keep the average duration in their bond portfolios in the intermediate term (4 to 7 years for taxable bonds and 5 to 10 for municipal bonds) while limiting exposure to riskier assets such as high-yield and emerging-market bonds.
Puerto Rico bonds
All three of the major ratings agencies cut Puerto Rico's general obligation (GO) bonds last week from investment grade to sub-investment grade. On February 4, Standard & Poor's lowered its rating on Puerto Rico's GO bonds to BB+ with negative CreditWatch. Moody's followed on February 7, cutting its rating from Baa3 to Ba2 with a negative outlook. Lastly, Fitch lowered its rating from BBB- to BB with a negative outlook. While the downgrade wasn't a surprise for most market watchers, we believe municipal investors should be aware of some issues related to Puerto Rico bonds.
Both S&P and Moody's downgraded Puerto Rico due to weak liquidity and questions about access to lines of credit. According to S&P, the downgrade reflects its concerns that the Commonwealth of Puerto Rico will have limited access to cash from the Government Development Bank (GDB) or other means. The GDB is a primary source of liquidity for the Commonwealth. To help fund liquidity needs and to repay short-term borrowing to the GDB and other sources, Puerto Rico is planning a sizable bond issuance in the near term. The need for such a large amount of outside liquidity—totaling $1 billion or more, according to S&P estimates—is the major reason for the downgrade. Due to the downgrades, however, the Commonwealth's cost of capital may rise, which may put further pressure on Puerto Rico.
Many market participants may have already expected the downgrades. Puerto Rico's bonds have been trading at sub-investment grade prices since September 2013, as shown in the chart below. The yields on bonds issued by the Commonwealth rose sharply starting in May 2013, well before the recent downgrades. While noteworthy, we're not shocked at the downgrades, or the rise in the cost of the island's borrowing either. Puerto Rico has an unemployment rate of 15.4% compared to the national rate of 6.7%,1 a funded pension level of 11% compared to the national median of 70%,2 and declining economic activity. And while the latest government has taken some steps toward financial reform, a pattern of excessive borrowing has created sizable deficits and liabilities to dig out from.
Puerto Rico bonds have been trading at "junk" levels since September 2013
Source: Barclays Puerto Rico Municipal Bond Index and Barclays Municipal High Yield Index, as of February 12, 2014.
Many bond funds hold Puerto Rican bonds, in particular state-specific funds. Puerto Rico isn't just a side story in the muni market. It's a sizable issuer, with about $70 billion in debt outstanding, and it is very popular among many U.S. investors for the triple tax exemption. In other words, interest paid on Puerto Rican bonds is exempt from federal, state and local income taxes in all 50 states. In addition, the higher yields relative to other local issuers have increased the popularity of Puerto Rican bonds. Many bond funds—in particular state-specific tax-exempt funds—have purchased Puerto Rican debt to boost yield without incurring an increase in state taxes. While some fund managers may be required to sell existing holdings, others may have more flexibility. However, most will not be able to purchase additional debt, which could put additional pressure on the Commonwealth's cost of borrowing.
Not all Puerto Rico bonds, however, are sub-investment grade rated. Certain Puerto Rico bonds may carry some form of insurance that helps to boost their credit rating, while some Puerto Rico bond issuers still carry investment grade ratings. The chart below shows the current tax-free funds listed on Schwab's OneSource Select list and their exposure to Puerto Rico bonds, according to data from Bloomberg. The height of each bar is the total percentage of the fund that is invested in bonds that are issued from issuers domiciled in Puerto Rico. The height of the light blue bar shows those bonds from issuers that carry sub-investment grade ratings.
Some national municipal bond funds hold Puerto Rico debt
Source: Bloomberg, as of February 11, 2014.
Note: For illustrative purposes only and not to be used as a recommendation. A table of ticker symbols and their corresponding full names can be found below.
What to do now. We believe the situation in Puerto Rico is serious and has the potential to get worse before it gets better. While the risks may already be priced in, we would only suggest investors with a significant appetite for risk consider holding Puerto Rico bonds. Investors who hold Puerto Rico bonds need to be prepared for price volatility and further downgrades if the Commonwealth is not able to smoothly access capital markets, or other sources of borrowing, in the near-term. Investors who own municipal bond mutual funds can view the top 10 holdings of the fund directly on Schwab.com.
Corporate bond credit quality
Investing in corporate bonds isn't always straightforward. A bond rated AAA and a bond rated BBB might both be rated investment grade, but there's a big difference in credit quality between the two. Likewise, in the sub-investment grade market, there's a big difference between a BB rating and a CCC rating. What do investors need to know about the various credit ratings, and where can they find value?
A primer on credit ratings. A credit rating is an indication of the creditworthiness of an issuer. Many types of bonds, like government, corporate, or municipal bonds, for example, have credit ratings. Credit ratings aren't a guarantee of performance; rather, they are the rating agency's opinion on the issuer's ability to pay back the bonds. All else being equal, the higher the credit rating, the lower the risk of default, according to the rating agency. Higher credit ratings mean that the rating agency has a strong view that the issuer will be able to pay interest and principal as scheduled.
Bonds with lower credit ratings have been more likely to default. As seen in the chart below, lower-rated corporate bonds have historically had a higher probability of default. So the ratings have worked well on average. While bonds with lower ratings have defaulted more frequently over a 15-year period after the rating was assigned, there is a clear jump in frequency of default for those bonds rated below investment grade. The significant increases in default rates for sub-investment grade bonds should be a good reminder that these investments carry significant risks, and that they should only be considered for investors with an aggressive risk tolerance.
Lower bond credit quality corresponds with higher default rates
Source: Schwab Center for Financial Research with data from Standard & Poor's 2012 Global Corporate Default Study. The study analyzed the rating and default history of 16,005 U.S. and non-U.S. companies first rated by Standard & Poor's between December 31, 1981 and December 31, 2012. The 15-year cumulative average default rate is calculated by weight-averaging the marginal default rates in all static pools. Past performance is no indication of future results.
Lower credit ratings generally mean higher yield spreads. The yield spread is the additional yield a corporate bond offers compared to a Treasury bond with a comparable maturity. Since U.S. Treasuries have little or no credit risk, the yield spread is compensation for the increased risk of owning a corporate bond. According to data from Barclays, the average yield spread increases as the average credit rating declines.3 For example, the BBB-rated sub-index of the Barclays U.S. Corporate Bond Index offers a higher average spread than the A-rated sub-index. If this seems obvious, it should; investors should be compensated more for the risk of investing in securities with lower credit ratings.
Incremental yield spread—by how much did the spread increase? We think investors should focus on how much the yield spread changes with each change in rating. The incremental yield spread is the additional spread earned by moving down a credit rating. The chart below shows the incremental yield spread for the various sub-indexes (based on credit rating) of the Barclays U.S. Corporate Bond Index and the U.S. Corporate High Yield Bond Index. For example, the average spread of the A-rated sub-index is 29 basis points (0.29%) higher than that of the AA-rated sub-index.
Incremental spread by lowering credit rating
Source: Barclays, as of February 12, 2014. Option-adjusted spreads (OASs) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. Incremental OAS represents the additional OAS earned from the labeled sub-index relative to the sub-index with one higher credit rating. Each credit rating represents the various credit-rating specific sub-indices of the Barclays U.S. Corporate Bond Index and Barclays U.S. Corporate High Yield Bond Index.
As shown in the above chart, the incremental spread increases up until the BB-rated sub-index, then it declines. We're not surprised that there is such a large increase from the investment grade rung of BBB to the sub-investment grade rung of BB, since many investors are prohibited from purchasing sub-investment grade bonds. However, the incremental spread to the B-rated sub-index is smaller than that of BB, even though B-rated bonds have had significantly higher average default rates through the years. For investors interested in investment grade bonds, we think the increased spread by moving from A-rated bonds to BBB-rated bonds looks attractive. For more aggressive investors looking at sub-investment grade bonds, we think it makes the most sense to stick with those bonds rated BB, and we see less value in reaching lower in credit quality for a lower incremental yield spread.
What to do now. Individual investors can use credit ratings as a way to target bonds that fit their risk/reward criteria. When looking at bonds with lower credit ratings in an effort to boost yields, make sure the yield is high enough to compensate for the risks. For investment-grade corporate bond investors, we think bonds rated BBB look attractive, given the higher incremental yield spread. For sub-investment-grade investors, we would stick with bonds rated BB. We don't think the yields on bonds rated B or below are high enough to compensate for the risks, like the increased risk of default. But dont just look at yields when making investment decisions. Make sure whatever corporate bonds you invest in are appropriate given your risk tolerance.
Why own bonds?
Even after a steep increase last year, bond yields are still low by historical standards. Depending on the pace of economic growth, we think there’s a greater chance for yields to move higher than lower in 2014. With that expectation, some investors may question why it makes sense to hold bonds at all. While it's true that bond prices and yields move in opposite directions—meaning higher yields lead to lower prices—we don't think investors should avoid bonds altogether. Bonds still offer many benefits, and we think they should remain an important part of most investors' portfolios.
Coupon payments can help offset price declines. That's the beauty of bonds—they offer coupon payments for investors looking for a consistent stream of income. While it's true that a higher yield will lead to a lower bond price, that's only half of the equation when it comes to performance. For most traditional bonds, total return is composed of price return and income return. Take, for example, a five-year bond with a 3% coupon, priced at par to yield 3% annually. If interest rates rise by 100 basis points (1%), the price of the bond will drop by approximately 4.6%, all else being equal.4 However, you'll still earn your 3% coupon, resulting in a one-year total return of about −1.6%. That return, however, would only be realized if an investor sold the bond. While the price return can fluctuate, the income return is always additive for bonds that have a coupon payment and this can help to act as a buffer to falling prices.
Not all bonds are alike. It's easy to focus on the ups and downs of the yield on the benchmark 10-year Treasury bond, but there's a large, varied universe of fixed income investments out there. If long-term interest rates rise as we expect this year, some bonds are likely to perform better than others. Focusing on the maturity and credit profile of the bonds can help investors mitigate some of the impact of rising rates on their fixed income investments.
A bad year for bonds has historically been very different from a bad year for stocks. Since its inception in 1976, there have only been three years in which the Barclays U.S. Aggregate Bond Index has generated a negative total return. The S&P 500 Index, on the other hand, has generated negative total returns in seven years over the same time period. And the magnitude of the decline in bonds was significantly lower than that of stocks, as seen in the chart below. The worst total return of the Barclays U.S. Aggregate Bond Index was −2.92% in 1994. This compares to −37.00% total return for the S&P 500 Index in 2008, the worst total return of our study. We think it's important to highlight the 2013 performance of the Barclays U.S. Aggregate Bond Index. For the year, 10-year Treasury yields increased by 128 basis points—from 1.75% to 3.03%—but the total return of the aggregate bond index was only −2.02%. While no one wants a negative total return from their bond holdings, we think that the total return was better than many would have imagined considering the dramatic rise in Treasury yields.
Since 1976, the worst-performing years for stocks were much more negative than the worst years in bonds
Source: Schwab Center for Financial Research with data provided by Morningstar, Inc. The chart shows the three lowest total annual returns from 1976 through 2013. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.
Bonds mature. Any change in market yields on the price of a bond may not matter much if you buy bonds for the known maturity and cash flow. Many investors purchase bonds for the relative safety compared to stocks and the predictability of income they provide. The most important factors are that they make coupon payments, and then repay principal on the maturity date. And bonds can play a large role in financial planning. Since bonds mature on a specified date, barring default, investors know how much money they'll have available in the future. This can help with specific fixed expenses down the road, such as education expenses or income needed for retirement. These characteristics are specific for individual bonds, not bond funds. While many investors may be concerned that the price of a bond fund will likely drop when rates rise, an investor holding individual bonds to maturity doesn't necessarily need to worry about that.
Bonds help diversify an overall portfolio. Different investments serve different purposes in a portfolio. Eliminating one could result in a more volatile portfolio. A properly diversified portfolio should have various asset classes that don't all perform the same under different market conditions. If one asset class is going down, you don't want all of your other investments going down as well, although this can happen. To look at the diversification benefits of various asset classes, we look at their historical correlations with each other. Correlation is a statistical measure of how investments move in relation to each other. Over the past 20 years, the Barclays U.S. Aggregate Bond Index and the S&P 500 Index have had a correlation of 0.04—almost no correlation at all. This can help reduce the overall volatility of an investor's portfolio.
What to do now. While the prospect of rising Treasury yields will likely lead to lower bond prices, that doesn't mean investors should avoid bonds altogether. Moreover, bonds can generate a positive total return, even in a bond bear market. We think it's important to remember the income and diversification benefits bonds provide in an overall portfolio. Selecting the right type and maturity of bonds in a well-balanced portfolio can be key to managing the interest rate environment.
1. Bureau of Labor Statistics, as of December 2013.
2. Standard and Poor's, "A Bumpy Road Lies Ahead For U.S. Public Pension Funded Levels," July 16, 2013.
3. Source: Barclays, as of February 13, 2014. Barclays U.S. Corporate Bond Index and Barclays U.S. Corporate High Yield Bond Index
4. The duration of a five-year bond with a 3% coupon priced at par is approximately 4.6. All else being equal, an increase in yield of 100 basis points (1%) results in a fall in price equal to the duration. In this example, the fall in price would be 4.6%.
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Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.
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. High yield and lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.
Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
The Bloomberg Economic Surprise Index (ESI) shows the degree to which economic analysts under- or over-estimate the trends in the business cycle. The surprise element is defined as the percentage (or percentage point) difference between analyst forecasts and the published value of economic data releases. The analyst forecasts are surveyed by Bloomberg News and displayed on the ECO
Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch.
Both the Barclays Puerto Rico Municipal Bond Index and the Barclays Municipal High Yield Index are components of the Barclays Municipal Bond Index.
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. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more.
Standard & Poor's 500 Index is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors.
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, economic or politcal 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.