Corporate Credit Outlook: Focus on Quality

December 8, 2022 Collin Martin
With economic growth expected to slow, we'd avoid reaching for yield in junk bonds. Higher-rated bonds are likely to fare better and are offering their highest yields in in years.

After a difficult 2022 so far, we generally have a more positive outlook on the corporate bond market for 2023. We believe the worst is behind us for investment-grade corporate bonds and preferred securities, but we expect volatility—and more potential price declines—in high-yield bonds and bank loans.

Our theme for the new year is "quality." With economic growth expected to slow and recession risk still high, we suggest investors focus on higher-rated investments. Rather than reach for yield in the lower-rated parts of the market, we'd rather focus on those with investment-grade ratings and the relatively high (often 5% or higher) yields they tend to offer. There may be better opportunities in 2023 within the riskier parts of the market—like sub-investment-grade, or "junk," bonds—but they are likely to see price declines before they get there, which would be painful for those holding these investments.

Federal Reserve policy and tighter financial conditions are key risks. Once rates become restrictive, that should slow demand and in turn slow economic growth. Corporate profit growth should be challenging over the next few quarters, as well. Corporate profits actually declined in the third quarter of 2022, according to the Bureau of Economic Analysis, and with borrowing costs on the rise and consumer spending likely to slow, we don't expect much growth in the next few quarters.

Corporate profit growth turned negative in the third quarter

Chart shows quarter-over-quarter change in U.S. corporate profits dating back to September 2018. Corporate profit growth was negative in the third quarter of 2022.

Source: Bloomberg, using quarterly data as of 3Q2022.

US Corporate Profits With IVA and CCA Total SAAR (CPFTTOT Index). Note: Y-axis is truncated at 12%; actual increase for 3Q20 was 23%.

If corporate profits remain stagnant or continue to decline, we believe high-yield issuers are more at risk than investment-grade issuers. High-yield issuers tend to have weaker balance sheets and more volatile cash flows, so when corporate profits slow, there's little wiggle room for many issuers to remain current in servicing their liabilities. And as economic growth slows, the number of high-yield defaults should keep ticking higher.

Here's a quick summary of our views. Below, we provide more details about the various parts of the bond market, highlighting some areas of opportunity and some potential pitfalls.

Table gives summary guidance for four asset classes, including that investors should consider investment-grade corporates, given that yields are at their highest levels in years.

Source: Schwab Center for Financial Research

Investment-grade corporate bonds

Investment-grade corporate bonds appear attractive given the rise in yields during 2022. Despite our economic and corporate profit growth concerns, we believe investment-grade corporate bond issuers should be able to hold up well. Their balance sheets are strong because they were generally able to lock in low interest rates over the last few years, and they tend to have more stable cash flows than high-yield issuers. Most investment-grade rated issuers have more diversified funding sources, and their bond maturities tend to be spread out. If an investment-grade issuer needs to refinance a maturing bond at higher yields today, it will likely have a smaller impact on the issuer's overall interest than it would for most high-yield issuers.

The average yield-to-worst of the Bloomberg U.S. Corporate Bond Index is now above 5%, down from just over 6% in October. Aside from that recent high, yields are still at the highest levels since 2009, and other than the surge in 2008 and 2009, yields are not too far below their 20-year highs. In the five years leading up to the 2008 financial crisis, the average yield of the index was 5.2%, very close to the current levels. Investors don't need to wait for higher yields with investment-grade corporate bonds, because they are already here.

Corporate bond yields are at their highest levels in years

Chart shows the average yield-to-worst for the Bloomberg U.S. Corporate Bond Index, which is currently at 5.1%, compared with the pre-financial-crisis five-year average of 5.2%.

Source: Bloomberg, using weekly data as of 12/2/2022.

Bloomberg U.S. Corporate Bond Index (LUACTRUU Index). Yield-to-worst is the lower of the yield-to-call or the yield-to-maturity. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. For illustrative purposes only. Past performance is no guarantee of future results.

There are still risks of course. Spreads—that is, the amount of yield compensation corporate bonds offer above comparable Treasuries—could rise modestly higher as economic growth slows, but we expect any potential rise to be small. We expect Treasury yields to fall in 2023, which could offset some of the possible spread widening and help keep prices supported.

Investor takeaway: Investment-grade corporate bond yields appear attractive today given the recent rise in yields. To help find investment options, you can explore funds on the ETF Select List or Mutual Fund Select List under the "Corporate Bond" category. You can also consider a separately managed account.

Investor takeaway: Investment-grade corporate bond yields appear attractive today given the recent rise in yields. To help find investment options, you can explore funds on the ETF Select List or Mutual Fund Select List under the "Corporate Bond" category. You can also consider a separately managed account.

High-yield corporate bonds

We're much more cautious on high-yield bonds, for three key reasons:

1. Spreads are relatively low. Corporate bond yields are generally composed of a Treasury yield plus a "spread," referenced above, meant to compensate investors for the risk of investing in riskier bonds. The average option-adjusted spread of the Bloomberg U.S. Corporate High-Yield Bond Index is down to just 4.4% after rising to 5.8% over the summer.

At 4.4%, the average spread of the index is right near the 10-year average of 4.3%, but we believe risks are elevated today. Investors should consider high-yield bonds when they are being compensated appropriately, but that's not the case today.

2. Spreads tend to rise leading up to a during a recession. The chart below highlights that spreads are well below previous peaks hit over the last 20 years and that spreads are usually higher when we enter a recession as the gray shaded areas illustrate. If growth slows as we expect, spreads should rise.  

High-yield spreads tend to rise during recessions

Chart shows the average option-adjusted spread of the Bloomberg U.S. Corporate High-Yield Bond Index dating back to 2000, with shaded portions showing recessions. The spread tends to rise leading up to and during recessions.

Source: Bloomberg, using weekly data as of 12/2/2022.

Bloomberg U.S. Corporate High-Yield Bond Index (LF98TRUU Index) Option-adjusted spreads (OAS) 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. Shaded columns represent recessions. For illustrative purposes only. Past performance is no indication of future results.

High-yield bonds tend to perform poorly when the yield curve (the difference between shorter- and longer-term yields) is inverted. The 2-year/10-year Treasury yield curve has been inverted since July, while the 3-month/10-year yield curve only dropped below zero in November.

The table below illustrates the 12-month excess returns (return relative to Treasuries) of the Bloomberg U.S. Corporate High-Yield Bond Index depending on the starting slope of the 3-month/10-year yield curve. The steeper the curve, the better the returns have been, while a flat or inverted yield curve has resulted in average excess returns below zero. We expect the yield curve to remain inverted as the Fed keeps hiking rates.

Average excess returns have been negative when the yield curve is inverted

Chart shows average excess returns for the Bloomberg U.S. Corporate High-Yield Bond Index when the starting slope of the 3-month/10-year Treasury yield curve is at different points. Historically excess return is negative when the yield curve is inverted.

Source: Bloomberg, using monthly data from August 1988 through October 2022.

Bloomberg U.S. Corporate High-Yield Bond Index (LF98TRUU Index) and Market Matrix US Sell 3 Month & Buy 10 Year Bond Yield Spread (USYC3M10 Index). Excess return is a measure of performance of a spread security over that of an equivalent Treasury security. Past performance is no indication of future results.

Given those concerns, we'd exercise caution with high-yield bonds and wait for better entry points later in 2023. As economic growth slows and recession risk remains elevated, spreads should rise—pulling prices down—as investors demand higher yields to compensate for those risks. Both Moody's and Standard & Poor's expect high-yield defaults to pick up over the next 12 months from their very low levels, which usually results in poor performance as well. We prefer investment-grade rated bonds now and would wait for better entry points next year for high-yield bonds.

Investor takeaway: Additional price declines and heightened volatility seem likely. Although their high yields may appear attractive at first glance, we suggest a cautious approach and believe there may be better entry points in 2023.

Investor takeaway: Additional price declines and heightened volatility seem likely. Although their high yields may appear attractive at first glance, we suggest a cautious approach and believe there may be better entry points in 2023.

Preferred securities

Preferred securities appear attractive for investors who have long investing horizons and can ride out some potential volatility. We don't expect prices to rise much in the near term, however.

The average yield-to-maturity of the ICE BofA Fixed Rate Preferred Securities Index is above 7% for the first time in more than a decade, and average prices have rarely been lower. Average coupon rates remain low at roughly 5%, so most issuers don't have much incentive to "call" (i.e., redeem) their preferreds.

Preferred securities have long maturity dates, or no maturity dates at all, but the issuers can usually "call" them after a specified period of time has passed. With market yields generally higher than the coupon rates on outstanding preferreds, it doesn't make economic sense to refinance preferreds today. In other words, most issuers wouldn't voluntarily issue a new preferred with a 7% yield in order to retire a currently callable issue with a 5% coupon rate, because that would increase the issuer's cost of servicing their preferreds.

The gap between market yields and coupon rates suggest that most preferreds will not be called any time soon

 Chart shows the yield-to-maturity and average coupon rate of the ICE BofA Fixed Rate Preferred Securities Index dating back to 2010. As of December 2, 2022, the yield to maturity was 7% and the average coupon rate was 5.1%.

Source: Bloomberg, using weekly data as 12/2/2022.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. For illustrative purposes only. Past performance is no guarantee of future results.

We don't expect prices to rise much in the near term as a result, but we still believe that preferreds still look attractive given their high yields. Banks and financial institutions are large issuers of preferreds, and we believe their fundamentals generally remain strong. Slow economic growth might eat into their profit margins, but we believe most major domestic banks are well-capitalized given the financial regulations put in place after the 2008 financial crisis. We believe the risk of dividend suspension for investment-grade preferreds is low.

Investor takeaway: Preferred securities appear attractive for investors who have a long investing horizon and are willing to ride out the ups and downs. We don't expect much price appreciation in the near term, but preferreds can still make sense for income-oriented investors.

There are a number of ways to invest in preferred securities. Schwab clients can use the Preferred Shares Screener when looking for individual preferreds, or you can explore funds on the ETF Select List or Mutual Fund Select List under the Morningstar category of "Preferred Stock." You can also consider a separately managed account.

Investor takeaway: Preferred securities appear attractive for investors who have a long investing horizon and are willing to ride out the ups and downs. We don't expect much price appreciation in the near term, but preferreds can still make sense for income-oriented investors.

There are a number of ways to invest in preferred securities. Schwab clients can use the Preferred Shares Screener when looking for individual preferreds, or you can explore funds on the ETF Select List or Mutual Fund Select List under the Morningstar category of "Preferred Stock." You can also consider a separately managed account.

Bank loans

Bank loans are a type of corporate debt with sub-investment-grade, or "junk," credit ratings. They are secured by a pledge of the issuer's assets and have floating coupon rates. They're usually only available to large institutional investors, so for most individual investors the only way to access the market is through a mutual fund or ETF.

We believe bank loan prices are at risk of modest price declines in 2023 given their low credit ratings and exposure to rising interest rates.

There are pros and cons to bank loans' floating coupon rates. For investors, it means that income payments tend to rise when the Fed hikes rates. But it also means that bank loan issuers are hit with higher interest payments in real time. For most corporate bonds, coupon rates are fixed, so issuers are only at risk of higher borrowing costs if or when they need to issue new debt. That's not the case with bank loans because their coupon rates frequently reset.

Given the aggressive pace of rate hikes, the interest expense of most bank loans has risen sharply. In 2021, for example, the average coupon rate for the bank loan universe was roughly 3.5%, assuming a short-term reference rate of just above zero and average spreads of 3.25% to 3.5%. With the federal funds rate now in the 3.75%-to-4% range, the average interest expense for many loans has doubled, and it should keep rising as the Fed hikes rates.

Bank loan income payments may keep rising, but that also means rising interest expense for the issuer

Chart shows the secured overnight financing rate, or SOFR, going back to August 2018, and the federal funds futures implied rate using monthly expectations for the period from December 5, 2022, through February 2024. Bank loan coupons are based on a reference rate like SOFR plus a spread. As short-term rates rise, so too should bank loan interest expenses.

Source: Bloomberg.

United States SOFR Secured Overnight Financing Rate (SOFRRRATE Index) using weekly data through 12/5/2022, and Fed funds futures implied rate using monthly expectations through February 2024. For illustrative purposes only. Futures and futures options trading involves substantial risk and is not suitable for all investors. Please read the Risk Disclosure Statement for Futures and Options prior to trading futures products. Futures accounts are not protected by SIPC. 

Given the rising input and labor costs already burdening many corporations, rising interest expense is one more factor that can eat into corporate profit margins. Like high-yield bonds, bank loan prices may fall modestly lower from here, but total returns may still be positive as higher income payments may offset some of the price declines. Like high-yield bonds, however, we believe there could be better entry points down the road.

Investor takeaway: Bank loan floating coupon rates can be a positive for investors but a negative for issuers. Like high-yield bonds, bank loan defaults are expected to rise in 2023 and we believe prices could fall modestly in the near term.

Investor takeaway: Bank loan floating coupon rates can be a positive for investors but a negative for issuers. Like high-yield bonds, bank loan defaults are expected to rise in 2023 and we believe prices could fall modestly in the near term.

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Preferred securities are often callable, meaning the issuing company may redeem the security at a certain price after a certain date. Such call features may affect yield. Preferred securities generally have lower credit ratings and a lower claim to assets than the issuer's individual bonds. Like bonds, prices of preferred securities tend to move inversely with interest rates, so they are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and preferred securities, when sold before maturity, may be worth more or less than original cost. Preferred securities are subject to various other risks including changes in interest rates and credit quality, default risks, market valuations, liquidity, prepayments, early redemption, deferral risk, corporate events, tax ramifications, and other factors.

Bank loans are typically below investment-grade credit quality and may be subject to more credit risk, including the risk of nonpayment of principal or interest. Most bank loans are floating rate, with interest rates that are tied to LIBOR or another short-term reference rate, so substantial increases in interest rates may make it more difficult for issuers to service their debt and cause an increase in loan defaults. Bank loans are typically secured by collateral posted by the issuer, or guarantees of its affiliates, the value of which may decline and be insufficient to cover repayment of the loan. Many loans are relatively illiquid or are subject to restrictions on resales, have delayed settlement periods, and may be difficult to value. Bank loans are also subject to maturity extension risk and prepayment risk.

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