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2018 Mid-Year Credit Outlook: Rising Yields, Growing Debt Levels

Key Points
  • Floating-rate investments have outperformed fixed-rate investments. We think that trend will likely continue in the second half of the year.

  • There are growing concerns about the size of the corporate bond market. We do think it poses a risk to the market over the long run, but we view it as less of a risk in near term.

  • Yields have risen, meaning investors can earn higher yields today than they have over the past few years.

The first half of 2018 was a mixed bag for corporate fixed income investments. Floating-rate investments managed to deliver positive total returns, but returns weren’t as strong for those with fixed coupon rates. Investment-grade corporate bond returns were especially disappointing. The 3.3% loss was the worst semiannual return of the Bloomberg Barclays U.S. Corporate Bond Index since 2013.

Total returns in the first half of the year were mixed

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 12/31/2017 through 6/29/2017. 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.

What’s in store for the second half of the year? We think more of the same is likely. We expect U.S. Treasury yields to continue to rise modestly as the Federal Reserve gradually boosts its benchmark rate range, potentially pulling up the yields of corporate fixed income investments as well. This could lead to modestly lower prices, in our view. We don’t expect returns for investment-grade corporate bonds to be as poor in the second half as they were in the first, but the markets are still challenging.

Below we’ll discuss our outlook for specific types of corporate investments, but first we’ll discuss the growing concerns about the size of the corporate bond market.

Corporate debt is rising

The size of the corporate bond market has grown sharply over the past decade. Much of that increase has been concentrated in the investment-grade corporate bond market. Since the end of 2008, the amount outstanding of the Bloomberg Barclays U.S. Corporate Bond Index has more than doubled, to $4.9 trillion.

Notably, the growth in corporate debt outstanding has far outpaced the growth of the U.S. economy. As a percent of real gross domestic product (GDP), the amount of nonfinancial corporate debt has surpassed the previous peak from 2008 and continues to rise.

Source: St. Louis Federal Reserve, using quarterly data as of 1Q 2018. Nonfinancial Corporate Business; Credit Market Instruments; Liability, Billions of Dollars, Quarterly, Seasonally Adjusted (BCNSDODNS) and Real Gross Domestic Product, Billions of Chained 2009 Dollars, Quarterly, Seasonally Adjusted Annual Rate (GDOC1).

What’s been behind this surge? Since the end of the financial crisis, U.S. corporations took advantage of record-low borrowing costs, issuing more and more debt with low coupon rates. They also issued more long-term debt. This combination generally helped firms lower their interest expense—by refinancing high-coupon debt with low-coupon debt—but also helped push back the risk of default for many issuers. By extending maturities, many issuers reduced their refinancing risk.

This sharp increase in corporate debt outstanding does pose a risk over the long run. After all, that mountain of debt will need to be repaid or refinanced—potentially at higher rates. That can pose a risk come the next economic downturn. But we don’t see that in the foreseeable future, and for now corporations are able to service that rising debt load.

Corporate earnings remain strong, supported by the growing U.S. economy and the effects of the Tax Cuts and Jobs Act of 2017. Aggregate cash balances remain high, as well, according to data from the Federal Reserve. In fact, the amount of nonfinancial corporate debt relative to nonfinancial corporate liquid assets is now at its lowest reading since the early 1960s.

While this may pose a risk when this economic cycle takes a turn for the worst, for now we think that corporate issuers should generally be able to handle this rising amount of debt.

The ratio of corporate debt to liquid assets is at its lowest point since 1965

Source: U.S. Federal Reserve, using quarterly data as of 1Q 2018. Nonfinancial corporate business; liquid assets (broad measure) and Nonfinancial Corporate Business; Credit Market Instruments; Liability, Billions of Dollars, Quarterly, Seasonally Adjusted.

Investment-grade corporate bonds

Despite the headlines, investment-grade corporate bonds are beginning to look a bit more attractive for income investors. But given our outlook for modestly higher bond yields, price appreciation is probably limited and coupon payments will likely be a key driver of second-half returns.

Investment-grade corporates have been one of the worst-performing fixed income investments for two key reasons:

  • rising spreads
  • high average duration

Duration is a measure of interest rate sensitivity, and it’s related to a bond’s maturity. The higher the duration, the greater the sensitivity to changing interest rates. Since corporations have been issuing more and more long-term debt, the average duration of the Bloomberg Barclays U.S. Corporate Bond Index has been rising and is now just below its all-time high. The high average duration is a key reason the investment-grade index has been such a poor performer this year—its average price is more sensitive to the rise in yields we’ve witnessed this year.

But credit spreads—or the amount of yield a corporate bond offers relative to a Treasury security—also have widened. That combination of higher Treasury yields and wider spreads has pushed up the average yield of the index to 4%, its highest level since 2011.

Still waiting for higher yields? They’re here

Source: Bloomberg, using monthly data as of 6/29/2018. Yield-to-worst is the lowest potential yield for a bond. It’s the lower of the yield-to-call or the yield-to-maturity.

But risks in the investment-grade market are rising. In addition to the rising average duration, the average credit rating of the index has been declining. Issues with BBB ratings (the lowest rung on the investment-grade ladder) have been making up a growing share of the index, meaning investors who are tracking an investment-grade index may be taking on more credit risk than anticipated.

Investor takeaway: Stay with your long-term, strategic allocation to investment-grade corporate bonds, but watch the average duration and the average credit rating of any fund or strategy that you’re invested in.

High-yield corporate bonds

We remain neutral on high-yield corporate bonds, as relative yields remain low and we expect volatility to pick up in the second half of the year. While the rising debt levels pose a risk in the long term, we think corporate fundamentals can keep prices supported in the near term.

At 3.6%, the average option-adjusted spread of the Bloomberg Barclays U.S. High-Yield Corporate Bond Index is well below its 20-year average of 5.6%, and not too far off the post-crisis low of 3.2%. In other words, the yield premium that high-yield investors receive today is near its lowest level in more than a decade.

High-yield spreads have rarely been lower

Source: Bloomberg, using monthly data as of 6/29/2018. 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.

We also expect a bit more volatility in the second half of the year compared to the low volatility of 2017. The high-yield index only posted negative total returns in three total months last year, the worst return being just -0.33%. That number has already been matched through the first six months of this year. With spreads so low, and the potential for bond yields to move modestly higher, there’s a rising risk of high-yield bond prices falling modestly.

We think high-yield total returns will be more volatile this year than last year

Source: Bloomberg, as of 6/98/2018. 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.

Investor takeaway: Stay with your long-term, strategic allocation to high-yield corporate bonds, but manage expectations for returns in the second half of the year. Income payments—not price appreciation—should continue to be a key driver of total returns, 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.

Floating-rate investments

Investment-grade floating rate notes appear relatively attractive today, and can make sense for investors who are nervous about the potential for interest rates to rise.

Investment-grade floating-rate notes, or “floaters,” are a type of corporate debt whose coupons are made up of a short-term reference rate plus a spread. The spread is considered compensation for taking on the risk of owning a corporate bond, as they typically come with additional risks, such as a higher risk of default. The reference rate for most floaters is the three-month London Interbank Offered Rate, or LIBOR. Floaters can offer investors two key benefits today:

  • Rising coupon payments: LIBOR is highly correlated to the federal funds rate. As the Fed gradually boosts its benchmark interest rate, the floater coupon payments should increase as well. Over the past year, the average coupon rate of the Bloomberg Barclays U.S. Floating-Rate Notes Index has risen to 3% from 1.9%.
  • Relatively stable prices: This is a key benefit of floating-rate investments. Since the floater coupon rates rise with short-term interest rates, their prices don’t need to adjust. (For fixed-rate bonds, yields and prices generally have an inverse relationship, so as yields rise, their prices tend to fall.)

Floater prices have held in a tight range for five years

Source: Bloomberg, using weekly data as of 6/29/2018. Bloomberg Barclays U.S. Floating-Rate Notes Index.

Investment-grade floaters do come with risks, of course. First, their prices won’t be as stable during an economic downturn or financial crisis. They are still issued by corporations, and if the economy enters a downturn, the creditworthiness of corporations tends to decline, leading to lower corporate bond prices. Second, financial institutions are a large issuer of floaters, making up more than half of the aforementioned floater index. This makes it difficult to get much sector diversification when investing in floaters.

Bank loans also have floating coupon rates, but they are very different from investment-grade floaters. They are issued by corporations, but they carry sub-investment grade (or “junk”) ratings, making them significantly riskier. Junk-rated investments generally have a greater risk of default than those with investment-grade ratings.

Bank loan coupon rates offer investors higher spreads due to those increased risks. The higher spreads have helped bank loans deliver higher total returns than floaters this year, but we think their prices will likely be a bit more volatile in the second half of the year.

Investor takeaway: Investment-grade floaters appear attractive today. The dual benefits of rising coupon rates and relatively stable prices even as the Fed continues to gradually raise rates can help investors stay invested today rather than waiting on the sidelines for yields to move even higher.

Bank loans should also reward investors with higher coupon payments in the second half of the year, but we think their prices will be more volatile, with a greater risk of price declines as we enter the late stages of the business cycle.

Preferred securities

Preferred securities are beginning to look more attractive, but we believe their prices are still at risk of suffering further declines if long-term interest rates rise modestly higher.

Preferred securities posted modestly negative total returns in the first half of the year on the heels of rising Treasury yields. Preferred securities have long maturities, or no maturity dates at all, making them highly sensitive to changes in long-term interest rates. As the 10-year Treasury yield rose by more than 40 basis points in the first half of the year, the average price of the ICE BofA Merrill Lynch Fixed Rate Preferred Securities Index dropped by 2.8%.

But preferred securities offer relatively high coupon payments—the average coupon rate of the index is 5.7%. The high coupon rate helped offset the drop in prices, resulting in a modestly positive first-half total return.

The rise in long-term bond yields has presented a slightly better entry point for preferred investors today. At roughly $102, the average price of the index is down more than four dollars since its 2017 peak, and it’s now slightly below its five-year average of $102.6.

Preferred prices have fallen this year

 

Source: Bloomberg, using monthly data as of 6/29/2018.

While we don’t think long-term Treasury yields will rise much further from their current levels, there is a risk that they can move higher in the short run due to rising Treasury supply and the Fed’s continuation of its balance sheet reduction process. Since that would likely pull preferred securities prices slightly lower, we’re not ready to offer a more favorable view just yet.

Investor takeaway: Preferred securities are beginning to look more attractive for long-term investors, as we think long-term yields are close to peaking. But we’re not ready to call the peak just yet, and any further rise in long-term yields would likely lead to modest price declines for preferred securities.

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Important Disclosures:

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 or economic 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.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

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. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

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.

While the market value of a floating rate note is relatively insensitive to changes in interest rates, the income received is highly dependent upon the level of the reference rate over the life of the investment. Total return may be less than anticipated if future interest rate expectations are not met.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar (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 ratings services. This index is part of the Bloomberg Barclays U.S. Aggregate Bond Index (Agg).

The Bloomberg 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.

The Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have $250 million minimum par amount outstanding and at least one year until final maturity.

The S&P/LSTA U.S. Leveraged Loan 100 Index is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market. The index consists of 100 loan facilities drawn from a larger benchmark - the S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan Index (LLI).

The BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed-rate USD-denominated preferred securities issued in the U.S. domestic market.

The Bloomberg Barclays U.S. Floating-Rate Notes Index measures the performance of investment-grade floating-rate notes across corporate and government-related sectors.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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