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Corporate Bond Investors: Check Your Sectors

Key Points
  • Corporate bond performance can vary based on the individual issuer, as well as the sector in which the issuer operates.

  • Commodity-related sectors have been hit hard, and remain a risk for investors. Rather than reach for yield here, we suggest caution.

  • More defensive sectors generally offer lower yields, but they likely come with fewer risks.

The sharp drop in commodity prices over the past 18 months has sent ripples through the corporate bond market. Energy companies have had a particularly rough ride. Plunging oil prices have raised concerns about their cash flows, leading to a spate of credit-rating downgrades and tumbling bond prices. Other parts of the market, meanwhile, have fared much better. 

In other words: Not all corporate bonds are created equal.

What does this mean for investors? First of all, we believe it makes sense to look beyond credit ratings and yields when it comes to investing in corporate bonds. The outlook for individual issuers and the health of their sectors can give investors a broader sense of any risks that might be lurking. As the performance of energy companies shows, different sectors can face unique risks.

Investors should also make sure their corporate bond portfolios are appropriately diversified. The fate of a portfolio shouldn’t hang on a single sector or issuer. 

Sectors and performance

To get a better sense of what’s happening in the corporate bond market, it helps to look at credit spreads. This is the difference in yield between a corporate bond and a U.S. Treasury security with a comparable maturity. The spread is basically a measure of relative risk. A smaller spread means the yield on a corporate bond is closer to that of a comparable Treasury, suggesting a lower risk of default. A wider spread means the corporate bond offers more yield—and potentially more risk.

The average option-adjusted spread (OAS) of the Barclays U.S. Corporate Bond Index is now 2.1%.1 However, average spreads vary among the three categories that make up the index—industrials, utilities and financial institutions—as well as among the different sectors within those categories.

As you can see in the chart below, the average spreads of energy and basic industry issuers are well above their long-term averages, reflecting the plunge in energy prices. Many other industries, however, are more in line with historical averages.

Average spreads can vary

Average spreads can vary

Source: Barclays U.S. Corporate Bond Index. Data as of 2/12/2016. The “15-year average” covers 2/2001 through 1/2016.

Industrials

Industrial bonds account for more than 61% of the Barclays U.S. Corporate Bond Index. But this is a broad category that encompasses a wide variety of sectors and industries. The table below shows how spreads vary among them.

Industrials

Source: Barclays U.S. Corporate Bond Index. Data as of 2/12/2016. The “15-Year Average,” “Low,” and “High” refer to the OAS from 2/2001 through 1/2016. 

Spreads on commodity-related issues are the widest. The energy sector—which includes things like independent energy companies, oil field services and midstream operators—and the basic industries sector—which includes chemicals, metals and mining, and paper businesses—lead the pack, with average spreads well above their long-term averages.

The plunge in commodity prices that started in the summer of 2014 has hit these sectors hard. The price of crude oil has fallen more than 70%, while commodities like iron ore, aluminum and copper have also dropped significantly.2 These declines have weighed on bond prices, as concerns about cash flows have grown. For example, the average price of bonds in the Barclays U.S. Corporate Bond Index’s energy sub-index has fallen to $89 from $108 just a year ago.3

Falling prices mean higher yields (and, therefore, wider spreads). While the higher yields available from this sector may look appealing against a backdrop of low interest rates, we would proceed with caution. The trend in commodity prices is still downward. Even if commodity prices do find some sort of bottom, low prices will likely continue to pose a credit risk for commodity-related issuers.

In early February, Standard & Poor’s (S&P) downgraded 10 U.S. investment-grade-rated exploration and production companies—with one of those dropping into sub-investment grade, or high-yield, territory.4 The agency also lowered its outlook for 10 other companies. That came after Moody’s placed 120 oil and gas companies and 55 mining companies around the world on review for downgrade the month before.

We would encourage investors to be wary of even investment-grade issuers in these sectors. We expect more downgrades to come, with more issuers potentially falling to junk status.

Spreads in the communications sector—which covers cable/satellite, media entertainment and telecommunications—are also wider than their long-term average, reflecting tough competition among telecom operators and challenges from technological changes in the sector. While the risks here appear to be lower than those of commodity-related issues, they shouldn’t be ignored.
Spreads on the other industrial sectors—transportation, consumer cyclical, technology, consumer noncyclical and capital goods—appear to be in roughly line with their long-term averages.

The consumer noncyclical sector—which covers things like food processing, beverages and household product makers—has one of the smallest average spreads in the broad industrials category, reflecting the historically more durable demand for such goods. Bonds from this sector could be a good option for investors looking for stability.

Financial institutions

Financial bonds account for roughly 31% of the Barclays U.S. Corporate Bond Index. This category covers banking, brokers, finance companies, insurance and bonds issued by real estate investment trusts (REITs).

Financial institutions

Source: Barclays U.S. Corporate Bond Index. Data as of 2/12/2016. The “15-Year Average,” “Low,” and “High” refer to the OAS from 2/2001 through 1/2016. 

Spreads on financial institution sector bonds are generally wider than their long-term average, though insurance company and REIT bonds are exceptions.

Finance company bonds now have the widest average spread. Global growth concerns and the potential for more corporate defaults may be weighing on this sector. But such bonds account for only a small part of the broader financial institutions category, representing just 2.6%.

Bank bonds account for most of the financial institutions category, representing more than 70% of all issues. They tend to be some of the larger, more diversified issuers, offering the lowest spreads of the bunch but also the highest average credit ratings.

REIT bond spreads are close to the long-term average, and fundamentals appear to be solid. S&P says slow but steady economic growth and “improving employment and consumer spending…will drive rent growth and occupancy.”5 However, Moody’s recently noted that many REIT bonds’ “financial profiles have deteriorated as a result of recent volatility in the debt and equity markets.”6

Overall, we think investors should be cautious with financial institution bonds. Recession risks are increasing and there’s a chance the energy sector’s troubles could lead to a rise in non-performing loans. These factors could weigh on financial institution issuers. 

Utilities

Utilities make up the smallest part of the investment grade market, with only an 8% weight in the Barclays U.S. Corporate Bond Index. This category encompasses electric utilities and natural gas. Electric utilities account for more than 91% of this category’s bonds.

Utilities

Source: Barclays U.S. Corporate Bond Index. Data as of 2/12/2016. The “15-Year Average,” “Low,” and “High” refer to the OAS from 2/2001 through 1/2016.

Utilities tend to be more stable than some other sectors, since they are generally highly regulated. Low oil and gas prices haven’t really affected utilities bonds, but their spreads have still widened slightly.

Moody’s and S&P both have a stable outlook on the utilities sector, although S&P has “a slight bias towards the negative.”7Low interest rates and slow but positive economic growth support the sector, but S&P notes that a recent uptick in acquisitions in the sector could pose a risk, especially for deals financed with debt. Utilities tend to be active borrowers, and a further rise in bond yields could make it more expensive to finance their debt.

What to do now

Given the weakness in commodities and growing risk of a recession, it might make sense to be cautious with corporate bonds, particularly those issued by companies with commodity exposure. We would counsel against just picking bonds according to their yields, as higher yields generally come with higher risks. A Schwab Fixed Income Specialist can help figure out what could work for you.

Talk to Us

  • Call a bond specialist at Schwab anytime at 877-908-1072.
  • Talk to a Schwab Financial Consultant at your local branch.
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