Investors looking forward to another strong year for corporate-related fixed income investments should probably curb their enthusiasm. Returns from many types of corporate bonds and preferred securities this year are far higher than those from Treasuries, thanks largely to rising prices backed by solid economic growth, easy financial conditions and declining defaults.
However, with relative valuations so high and the potential for yields to move modestly higher as the Federal Reserve continues to raise interest rates, we think things will look different in 2018. In particular, the price appreciation we saw in 2017 is unlikely to continue, leaving income payments as the primary driver of total returns in 2018.
Total returns have been strong in 2017
Corporate fixed income investments have posted strong returns so far this year, with most segments of the market outperforming Treasury bonds. Investors were likely attracted by the relatively higher yields on offer, causing the yield spread between corporate investments and Treasuries of comparable maturities to narrow. Because bond prices and yields move in opposite directions, a smaller spread means higher prices relative to Treasuries.
Preferred securities, meanwhile, benefitted from falling long-term Treasury yields, making them the strongest performer of any domestic fixed income asset class we track.
Corporate investments have generally outperformed Treasuries this year
Source: Bloomberg. Indexes represented are the Bloomberg Barclays U.S. Treasury Bond Index, Bloomberg Barclays U.S. Corporate Bond Index, Bloomberg Barclays U.S. Corporate High-Yield Bond Index, Bloomberg Barclays U.S. Floating-Rate Notes Index, BofA Merrill Lynch Fixed Rate Preferred Securities Index, and the S&P/LSTA Leveraged Loan 100 Total Return Index. Total returns from 12/31/2016 through 12/8/2017. 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.
Corporations appear to be in good shape, but valuations appear stretched
Credit spreads generally declined this year—and for good reasons. Economic growth remains steady and has actually shown some signs of improvement recently, with the U.S. economy expanding 3% in both the second and third quarters.
Solid growth should support corporate profits, as should the yet-to-be-finalized tax bill that’s currently working its way through Congress. Lower corporate tax rates should free up more money to pay bondholders, while lower individual tax rates could boost consumer spending.
Financial conditions also remain easy, which is a boon for corporations looking to refinance their outstanding debt. According to the Securities Industry and Financial Markets Association, U.S. corporations had issued more bonds through November than they did in all of 2016, marking the sixth straight year of rising new issuance. (Of course, more and more debt poses a risk to the corporate bond market down the road, as that debt will need to be repaid or refinanced, potentially at higher rates.)
Last, corporate defaults continue to fall. According to Standard & Poor's, the trailing 12-month speculative-grade default rate was 3.1% in November, below the 20-year average of 4.2% and down from more than 5% in December 2016. S&P expects the rate to drop to 2.8% by June 2018.
Defaults are down sharply over the past year
Source: Standard and Poor’s Trailing 12-Month Speculative-Grade Corporate Default Rate, 11/2017. S&P conducts its default studies on the basis of groupings called static pools. For the purpose of the study, S&P forms static pools by grouping issuers by rating category at the beginning of each year that the CreditPro database covers. Each static pool is followed from that point forward. All companies included in the study are assigned to one or more static pools. When an issuer defaults, S&P assigns that default all the way back to all of the static pools to which the issuer belonged. S&P calculates annual default rates for each static pool, first in units and later as percentages with respect to the number of issuers in each rating category.
But the price at which you invest matters, and today corporate valuations appear stretched. Credit spreads in almost all parts of the market are well below their long-term averages and at or near their post-crisis lows. That means investors simply aren’t earning much relative yield to compensate for the additional risks that come with investing in corporate fixed income assets.
All things considered, our outlook on corporate-related fixed income investments is neutral. We think strong corporate fundamentals should keep prices from falling sharply but relative yields are low. Below we’ll offer some additional insights as to what investors should be considering as we approach the new year.
High-yield corporate bonds
Our outlook on high-yield bonds is neutral due to low relative yields. At 3.4%, the average option-adjusted spread of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index is well below the 20-year average of 5.5% and very close to its post-crisis low of 3.2% reached in June 2014. Simply put, their relative yields are near the lowest level in more than a decade.
High-yield spreads continue to drop
Source: Bloomberg, using daily data as of 11/7/2017. 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.
This strong performance has come with a noticeable lack of volatility. High-yield corporate bonds tend to be volatile by nature—issuers tend to have riskier business profiles and they are more prone to default than investment grade corporate bonds. Such bonds also tend to be less liquid than high quality bonds like U.S. Treasuries or investment grade corporates. But lately, the high-yield bond market has been relatively calm.
Going back to February 2016, the monthly total return of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index has been positive in 18 of the past twenty-two months. And when losses have come, they’ve been relatively small—the worst monthly total return over that time frame was just –0.5%. That contrasts to the mid-2014 through 2015 period, when monthly total returns were much more erratic.
High-yield monthly total returns have mostly been positive for more than a year and a half
Source: Bloomberg, as of 11/30/2017. 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.
While we don’t expect to return to a period of large monthly drops, we also don’t think investors should be lulled into a false sense of security based on the past 22 months. Volatility could return to this market in 2018. One potential cause could be a proposal in the tax bill to limit the amount of interest that corporations can deduct from their earnings. Even a minor slip in cash flows could contribute to a rise in default risk.
Investor takeaway: Stick with your long-term, strategic allocation to high-yield corporate bonds, but manage expectations for total returns in 2018. Income payments will likely be a key driver of total returns, not price appreciation, and volatility may pick up. For investors who have shorter investing horizons or more conservative risk tolerances, consider moving up in quality to investment grade corporate bonds.
Investment grade corporate bonds
We’re also neutral on investment grade corporate bonds for many of the same reasons—mainly because credit spreads are low. In fact, the average OAS of the Bloomberg Barclays U.S. Corporate Bond Index is now at its post-crisis low and more than 60 basis points below its long-term average.
However, interest rate risk—the risk that the value of a fixed income security will fall as a result of a change in interest rates—is growing for the investment grade corporate bond market.
One way to measure a bond (or bond fund’s) interest rate sensitivity is to look at its duration. All else equal, the higher the duration, the more sensitive it is to changing interest rates.
The average duration of the Bloomberg Barclays U.S. Corporate Bond Index has been rising for years. Why? As interest rates remain at historically low levels, corporations have issued more and more longer-term debt to take advantage of such low financing costs. As a result, the average duration of the Bloomberg Barclays U.S. Corporate Bond Index is now at 7.5, up from 6.25 a decade prior and as low as 4.5 back in 1989.
Corporate bond duration has been rising
Source: Bloomberg. Monthly data of 11/30/2017.
As a result, investors who rely on the Bloomberg Barclays U.S. Corporate Bond Index to guide their investments may be unknowingly taking on more interest rate risk than they realize. With our expectation for yields to rise modestly in 2018, longer-duration investment grade corporate bonds could be at risk of steeper price declines than investments with more short- or intermediate-term durations.
Investor takeaway: Stick with your long-term, strategic allocation to investment grade corporate bonds, but watch the average duration of any fund or strategy that you’re invested in. If you’re looking to reduce your interest rate risk given our expectations of rising bond yields next year, you may need to tweak your corporate bond holdings to get the preferred exposure.
Preferred securities have posted some of the strongest fixed income total returns in 2017 due to a combination of both falling long-term yields and the higher coupon payments they offer. But the drop in yields has pushed prices up—the current price of the BofA Merrill Lynch Fixed Rate Preferred Securities Index is $105.5 Historically, prices this high have meant lower average total returns going forward. The chart below offers a glance at what the following 12-month returns are depending on the starting price. Today’s price falls in the left-most column.
Returns historically have been lower in the short term after prices peaked
Source: Schwab Center for Financial Research and Bloomberg. Forward 12-month total returns of the BofA Merrill Lynch Fixed Rate Preferred Securities Index using monthly data from 4/30/1989 through 11/30/2017. Past performance is no guarantee of future results.
Prices have rarely been this high. The all-time high of $107.6 isn’t far from current levels. Like most parts of the corporate fixed income market, we see little room for prices to rise from current levels, especially given our expectations that yields will rise modestly next year.
While coupon income may make up much of the total return in 2018, average coupon payments for preferred securities have been falling over the years. The average coupon rate of BofA Merrill Lynch Fixed Rate Preferred Securities Index is just 5.9% today, compared to 7% just five years ago.
Investor takeaway: Manage your return expectations and make sure you have a long-term investing horizon when investing in preferred securities. While there could be occasional bouts of volatility and modest price declines, the high coupons that preferred securities offer can help them generate positive total returns over longer investing horizons.
Not all floating-rate investments are created equally—over the past twelve months, some have benefitted from higher short-term rates while others haven’t. When investing in floating-rate investments, it’s best to understand the difference between investment grade floating-rate notes (also called “floaters) and bank loans.
Investment grade floaters are simply a type of a corporate debt. They carry investment grade credit ratings, and rather than having a fixed coupon rate, their coupons “float” based on a short-term reference rate. The reference rate for most floaters is the three-month London Interbank Offered Rate, or LIBOR, and floaters generally offer a “spread” above the reference rate to compensate for the additional risk involved, such as the risk of default. Also, financial institutions issues account for more than half of the investment grade floater market, making it difficult to get much sector diversification with these investments, while also raising the risk of price declines during periods of financial stress.
LIBOR is highly correlated to the federal funds rate, so when the Fed is raising rates, floaters tend to reward investors with higher income payments. As the chart below illustrates, the average coupon rate of the floater index has risen along with the rise in three-month LIBOR.
Investment grade floater coupon rates have risen this year
Source: Bloomberg, using weekly data as of 12/1/2017.
However, the average coupon rate of bank loans hasn’t experienced the same increase—in fact, average bank loan coupon rates have actually fallen this year.
Bank loans 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. Their coupon rates are also based off of three-month LIBOR plus a spread, but the spread is usually much larger for bank loans relative to investment grade floaters.
Bank loan average coupon rates have actually fallen this year because many issuers have been able to refinance their existing loans at lower spreads. The refinancing activity and lower spreads have actually resulted in a decline in average coupon rates this year. In other words, although LIBOR has risen this year, average income payments for bank loans have actually declined. (Even though they haven’t risen this year, bank loan coupon payments are still greater than those of investment grade floaters because bank loan spreads are wider. That’s why they have delivered modestly higher returns than floaters this year, even without an increase in coupon payments.)
Investor takeaway: Investment grade floaters and bank loans are very different investments with very different risk profiles. Investors interested in investments that are more likely to benefit from higher short-term rates may want to consider investment-grade floating-rate notes or funds that hold them. We think the flat to declining trend with bank loan coupon rates may continue as long as investor demand remains high and refinancing activity elevated.
What you can do next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
- Explore Schwab’s views on additional fixed income topics in Bond Insights.