What a difference a decade makes.
Following the 2008–2009 financial crisis, U.S. Treasuries yielded next to nothing, as investors fled to the relative safety of government-issued debt and the Federal Reserve slashed its benchmark interest rate to help stimulate the economy. Meanwhile, low borrowing costs and a growing U.S. economy helped riskier U.S. corporate bonds outperform their federal counterparts.
Today, U.S. Treasuries offer relatively attractive yields, while investment-grade U.S. corporate bonds last year suffered their worst annual performance in a decade.1
What happened? And could the U.S. corporate bond market continue its recent slide?
More of the same
We believe U.S. corporate bond yields are poised to move modestly higher throughout 2019 and into 2020—which could continue to pull prices lower and negatively impact total returns from U.S. corporate bond funds. (Remember, bond prices fall when yields rise.) Four key factors are to blame:
- A surge in U.S. corporate debt: Over the past decade, the amount of debt issued by nonfinancial U.S. companies ballooned 48%, to nearly $9.8 trillion—which is raising fears of a potential bubble (see “Precarious heights,” below).
- Rising interest rates: Repeated interest rate hikes have caused Treasury yields to rise, giving income-seeking investors a viable alternative to riskier U.S. corporate bonds, even as they’ve made it more expensive for corporations to borrow. Higher borrowing costs can eat into not only a company’s profitability but also its ability to service outstanding debt, increasing the risk of default.
- The rise of triple Bs: More than half the market now consists of U.S. corporate bonds rated the lowest in the investment-grade category (BBB+ through BBB- by Standard and Poor’s and Baa1 through Baa3 by Moody’s Investors Service). That could be a problem for risk-averse investors who rely on funds or strategies that passively track an index.
- The risk of downgrades: The investor base for high-yield U.S. corporate debt is limited, and if the glut of triple Bs previously mentioned is downgraded, the price of high-yield U.S. corporate bonds may need to move sharply lower in order to sufficiently entice prospective buyers.
Total nonfinancial U.S. corporate debt surged 48% from year-end 2008 through year-end 2018, raising concerns of a bubble.
Source: Bloomberg, as of fourth quarter 2018. Nonfinancial U.S. corporate debt is represented by FOF Nonfarm Nonfinancial Corp Business; Credit Market Instruments; Liability Index. Total debt includes both bonds and loans from private and public issuers.
What can you do?
As a result of these risks, we suggest investors take a more cautious stance toward U.S. corporate bonds in 2019. Investors needn’t abandon their U.S. corporate fixed income holdings, but they should consider moving up in quality.
Investors in triple-B-rated U.S. corporate bonds, for example, might consider reducing their exposure in favor of those with ratings of A or above. Although triple-B-rated corporate bonds were yielding 4.3% in mid-February, those rated A were yielding 3.6%—among their highest levels since 2011.2
Bond-fund investors, in particular, should bear in mind that many index-tracking investments have a lot of exposure to BBB-rated securities. If that’s outside your comfort zone, you may want to consider strategies that take a more active approach and focus on higher-rated parts of the market.
Finally, if you’re a high-yield U.S. corporate bond investor, make sure you’re comfortable with the risks. High-yield bonds can suffer large price declines in short periods of time. In the fourth quarter of 2018, for instance, the average price of the Bloomberg Barclays U.S. Corporate High Yield Bond Index dropped by more than 6%. If that kind of price decline is too steep for your tastes, consider moving up to higher-rated, intermediate-term bonds.
1Bloomberg Barclays U.S. Corporate Bond Index.
2Bloomberg Barclays Indexes, as of 02/19/2019. Comparison is based on the yield-to-worst of the Bloomberg Barclays U.S. Corporate A Rated Bond Index and the Bloomberg Barclays U.S. Corporate Baa Rated Bond Index.