Corporate Bonds: Taking Credit
- After strong price appreciation in most bond-market sectors last year, we expect 2012 to be a year when the bond returns will come largely from "earning the coupon," i.e. receiving interest income, rather than further price gains.
- Our slow-but-improving economic growth outlook, coupled with very low US Treasury bond yields, suggests that it may make sense to take more credit risk to obtain higher yields rather than to increase duration risk. Corporate bonds have historically outperformed Treasuries when the economy is growing.
- Investment-grade corporate bonds have had a strong start in 2012, so don't be surprised to see some pullback, but the yield spread between them and Treasuries remains within long-term historical averages. Consider using periods of price declines to focus on adding corporate bonds to a portfolio.
- Sectors such as bank bonds offer higher potential returns, but also higher risk. Similarly, high-yield bonds offer higher coupons and yields, but at increased risk.
Earn your coupon
Price appreciation was a major component of return for bond investors over the past year in the US Treasury market, but less so for corporate bonds. For 2011 as a whole, price appreciation accounted for more than two-thirds of the total return for longer-term Treasury bonds, with interest income accounting for the rest. For investment-grade corporate bonds, the price return was a smaller proportion at less than one-half the total, while for high-yield bonds, interest income actually offset a decline in prices.
Bond Sectors 2011 Total Returns
Source: Schwab Center for Financial Research and Barclays Capital, as of December 30, 2011. Note: Returns are compounded on a monthly basis. Sectors are represented by their corresponding index, defined below.
Due to strong performance over the past year, the upside potential in bond prices looks limited from current levels. After all, yields are at decade-low levels, and in many cases, are below the current rate of inflation. Recent economic data suggests that the economy is starting to show signs of improvement.
We don't expect the Federal Reserve to raise short-term interest rates this year, but if economic data points to stronger growth ahead, long-term rates—which are driven by market forces—could edge higher. Meanwhile, we see less likelihood that "flight to safety" buying will push yields lower this year. Actions taken by the European Central Bank (ECB) late last year to increase liquidity in the European banking system have helped calm global bond markets, reducing the flight to safety into US Treasuries.
Consequently, with price appreciation most likely to be limited, we expect 2012 to be a year when more of the total return in bonds comes from interest earned rather than price appreciation. (The term "Earning the coupon" refers back to when investors received physical bonds with coupons attached that bondholders clipped and sent in to receive interest payments. Bonds are no longer issued this way, but interest income received can still be referred to as "coupon" income.)
We continue to see the risk/reward for investors in investment-grade corporate bonds to be favorable. Based on Barclays Capital aggregate corporate bond indexes, the average coupon rate on intermediate-term securities (those maturing in the five-year time frame) is 5.1%. However, since most bonds are trading at premiums to par in this low-interest-rate environment, yields to maturity are lower, in the 2.5% to 3.5% range. Nonetheless, when compared to yields of less than 1% for Treasury securities with five years or less to maturity, corporate bonds have potential to provide more current income for comparable duration risk. Of course, don't forget that the reason for the higher yields for bonds of the same maturity is the greater credit risk, however slight, of the investment-grade corporates over the corresponding Treasuries.
The underlying fundamental outlook for the corporate bond market is sound in our view. Typically, corporate bonds outperform Treasuries when the economy is growing because companies generate stronger earnings and cash flow to meet their debts—factors that should lower the risk of default. As the chart below illustrates, when business-cycle activity increases (downward in the chart), the yield spread between corporate bonds and Treasuries narrows. Since we expect a moderate pace of economic growth in 2012 but very low interest rates to persist due to Fed policies, we expect corporate bonds to outperform Treasury bonds.
Corporate Bond Spread Versus Treasuries and the Business Cycle
Source: St. Louis Federal Reserve Industrial Production Index, percent change from year ago, monthly, seasonally adjusted and Barclays Capital US Baa Corporate Bond Option Adjusted Spread as of December 30, 2011. Option-adjusted spreads are quoted as a fixed spread, or differential, over US Treasury issues.
Another positive factor in the current cycle is that corporations have reduced leverage on their balance sheets over the past few years and increased holdings of liquid assets. This more-cautious management of balance sheets is a positive from a bondholder's point of view, since it provides more funds to cover interest payments to bondholders.
Corporations Holding More Liquid Assets
Source: Federal Reserve Board. Federal Reserve statistical release z.1 Flow of Funds Accounts of the United States, Flows and Outstanding Third Quarter 2011. Amounts outstanding end of period, not seasonally adjusted.
Market-based indicators also point to a decline in the perception of risk for corporate bonds. One way to assess expectations about risk in the sector is to look at the Markit Investment Grade CDX generic index. This index is based on the cost of insurance against defaults using credit default swaps, and it provides a broad measure of risk in the investment-grade corporate bond market. A lower reading implies lower risk. Recently, the trend has been lower, suggesting expectations that the risk of default are declining.
Markit Investment Grade CDX Index
Source: Bloomberg data using CDX IG CDSI GENERIC 5Y Corp as of February 1, 2012
For investors with higher risk tolerance, some sectors of the investment-grade universe offer higher yields. Of course, higher yields are accompanied by higher risks, as there's no free lunch in these markets. Nonetheless, it may be reasonable for some investors seeking yield to take more risk in these sectors. Specifically, the financial sector offers more yield than more-conservative sectors such as utilities in exchange for a higher risk of default.
In November, we published an article, "A Second Look at Bank Bonds," outlining our thoughts on the opportunity in this sector. Since then, financial bonds have benefited from the ECB's move to increase liquidity through the Long-Term Refinancing Operation. This program provides very low-cost loans to European banks for three years, with very permissive guidelines on the collateral required to back those loans. Since the program was launched in December, concern about contagion from European banks has eased and US bank bonds have rallied.
Given the magnitude of the rally, some caution is advised, but we nonetheless believe that at least some portion of the risk premium that's been embedded in this sector since 2008 is likely to decline, allowing prices to rise and yields to fall further over time. As of early February, yields for financial institution bonds were 0.75% to 1% higher than yields for industrial and utility bonds, respectively.
Source: Barclays Capital, daily data as of February 6, 2012. Indices shown are the Intermediate US Corporate Investment-Grade Financial Institutions, Intermediate US Corporate Investment Grade Utility and Intermediate US Corporate Investment Grade Industrial sub-sectors of the US Credit Index, Yield to Worst.
High-yield (or sub-investment-grade) bonds also offer extra income to investors. Up until February, high-yield bonds hadn't really participated in the overall bond-market rally because of concerns about weak economic growth and the potential for rising default rates. However, as economic data has shown improvement in the first quarter, high-yield bonds have begun to increase in price as well.
Nonetheless, average yields are still greater than 7% and average coupon rates on high-yield bonds are in the 6% to 8% range, based on the Barclays Capital High Yield Very Liquid Index. We suggest staying with the higher end of the high-yield market—those rated B or higher—to help mitigate the default risk in sub-investment grade bonds.
Take credit only where credit is due
While we see taking more credit risk as a reasonable way to add yield to a bond portfolio in a low-interest-rate world, be cautious. Higher-yielding bond sectors—both investment-grade and sub-investment-grade—are vulnerable to economic weakness and negative shocks.
The high-yield bond market in particular tends to be correlated with the trend in the stock market, and liquidity can dry up when negative market events occur, such as the crisis in 2008 and 2009. Even with increased liquidity in the European banking system and improved US economic data, more-aggressive, higher-yielding sectors are still vulnerable to negative surprises. Utilities, consumer staples and other less-cyclical sectors are likely to be more stable. So we suggest that you choose bonds carefully and limit exposure to high-yield and riskier sectors of the bond market, based on your personal risk tolerance.
S&P Index and High-Yield Bonds Source: Barclays Capital Database US Corporate High Yield Index and Bloomberg S&P 500® Index, monthly data as of December 30, 2011.
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