Positive outlook, low yields.
That’s our take on the corporate bond market in a nutshell. The present economic backdrop is supportive for corporate bonds, but such a strong outlook has pulled corporate bond spreads and yields to or near all-time lows. Even though risks appear relatively low, the low yields are a tough pill to swallow.
Year-to-date total returns have been mixed, at least through the end of May. The negative returns of the investment-grade corporate bond market garnered plenty of headlines, but high-yield bonds, preferred securities, and bank loans still delivered positive total returns.
Coupon payments have helped offset negative price returns
Source: Bloomberg. Total returns from 12/31/2020 through 5/31/2021. Indexes represented are the Bloomberg Barclays U.S. Corporate Bond Index (Investment-Grade Corporates), Bloomberg Barclays U.S. Corporate High-Yield Bond Index (High-Yield Corporates), ICE BofA Fixed Rate Preferred Securities Index (Preferred Securities), and the S&P/LSTA Leveraged Loan 100 Total Return Index (Bank Loans). 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.
High-yield corporate bonds and preferred securities did suffer negative price returns over that time frame, but the high coupon rates helped offset those price declines. We think this trend could repeat itself in the second half of the year—with yields so low and prices so high, there’s simply not much room for prices to rise further. Modest price declines in any of these investments wouldn’t necessarily be surprising, but the coupon payments can help offset that to a degree.
The possibility of modest price declines doesn’t mean investors should avoid all corporate bond investments. Rather, investors should consider investments with slightly lower average durations to help protect against a rise in yields, and consider adding some lower-rated, more aggressive investments—in moderation, of course—to help earn higher yields. Managing expectations is paramount in the current interest-rate environment. Coupon payments are likely to be a key driver of total returns over the next six to 12 months, as we see little room for prices to rise.
Strong fundamentals/low relative yields
The good news: Corporations are generally in great shape to service their debts. Corporate profits have been growing, financial conditions are seemingly easy, and corporations have, on average, plentiful liquid assets on their balance sheets. When financial conditions are easy, interest rates and borrowing costs are relatively low, and it’s relatively easy for borrowers to secure credit.
The bad news: The relative yields offered by many corporate bond investments today are at their lowest levels since the 2008-2009 financial crisis.
Investors should still consider corporate bond investments, despite the low yields, given such a currently strong economic backdrop. There are plenty of supporting factors that should prevent prices from falling sharply over the next six to 12 months, including:
- Corporations have plenty of liquidity, on average. Since the pandemic first struck in early 2020, corporations issued a record-breaking amount of debt to shore up their balance sheets. While that will likely be a risk over the long run, much of the proceeds have just been parked on corporate balance sheets in the form of liquid assets. In fact, over the last two years, the amount of aggregate liquid assets has grown more than the amount of debt outstanding.
Liquid assets have risen more than corporate debt outstanding
Source: Bloomberg, using quarterly data as of 4Q 2020. FOF Nonfarm Nonfinancial Corporate Business Liquid Assets NSA (NFCBCBLA Index) and FOF Nonfarm Nonfinancial Corp Business Credit Market Instruments Liability (CDNSCBIL Index).
- Upgrades are outpacing downgrades. After a wave of pandemic-driven downgrades in 2020, credit rating agencies have been upgrading more corporate bond issuers over the last handful of months. While the number of upgrades generally has been widespread, the trend is stronger in the high-yield market than the investment-grade market.
There have been more upgrades than downgrades in five of the past six months
Source: Bloomberg, as of 5/25/2021. Columns represent the ratio of upgrades to downgrades for both investment-grade and high-yield corporations from Standard and Poor’s from 1/1/2020 through 5/31/2021.
- Corporate profits are likely to rise sharply. Given the strong economic growth in the first quarter and what’s expected to be a strong year in total, we believe corporate profits should continue to rise. That could help improve corporate balance sheets even more and could keep the strong pace of upgrades going.
Investment-grade corporate bonds
We suggest a neutral allocation to investment-grade corporate bonds, but favor a below-benchmark average duration.
The average duration of the Bloomberg Barclays U.S. Corporate Bond Index is 8.6, just off its all-time high of 8.9 from earlier this year. Duration is a measure of interest rate sensitivity—the higher the duration, the larger the price fluctuations when yields move. The high average duration of the index is a key reason why corporate bonds performed so poorly to start the year. The average price of the index dropped sharply as the 10-year Treasury yield rose 60 basis points in the first five months of the year.
We believe the 10-year Treasury yield will resume its climb later this year and holding short- to intermediate-term corporate bonds can help limit some of the potential price declines. Through May 31st, the 1-3 year and 3-5 year corporate bond indexes posted returns of 0.36% and 0.1% , respectively, compared to a 2.9% loss for the broad index.
Corporate bond valuations appear very expensive on the surface, but we still think they make sense today. To value corporate bonds, we look at the credit spread, of the additional yield offered above a Treasury with a comparable maturity. The average spread of the index is at its lowest point since early 2007, but we believe spreads should be viewed differently in the current interest rate environment. The average spread of the index is just 0.84% but it makes up nearly 40% of the overall yield, just below the 10-year average. In other words, the credit risk compensation still makes up a relatively large chunk of the yield.
Credit spreads still account for roughly 40% of the overall yield
Source: Bloomberg, using weekly data as of 5/31/2021. Barclays US Agg Corporate Avg OAS (LUACOAS Index) and Bloomberg Barclays US Agg Corporate Yield To Worst (LUACYW Index). The line represents the spread divided by yield, illustrating how much of the yield is comprised of spread versus Treasury yield.
High-yield corporate bonds
The outlook for high-yield corporate bonds remains positive. Rising corporate profits make it easier for corporations to service their debt, and many of the sectors and industries most negatively affected by the pandemic are showing signs of life as the economy gets back to “normal.” High-yield new issuance remains robust, allowing high-yield issuers to refinance debt at historically low rates. After peaking at nearly 9% last year, the default rate has been trending lower, and forecasts point to it approaching the pre-pandemic lows of 2018 and 2019.
The high-yield default rate continues to decline
Source: Moody's, using monthly data as of 4/30/2021. Moody's, “April 2021 Default Report", May 10, 2021. Past performance is no guarantee of future results.
The strong outlook has pulled yields down to all-time lows. For better or for worse, investors are lending to corporations at very low rates, as the perceived risk of default is low with such a supportive economic backdrop currently. The average yield-to-worst of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index dropped as low as 3.9% in early May 2021, before closing the month at 4.0%. Prior to this current experience, that yield had only dropped below 5% for a few weeks back in 2014, and never even got close to the 4% level.
Investors can still consider high-yield bonds in moderation. Yields are low, but so is the average duration of the market. After accounting for interest rate risk, the yield advantage that high-yield bonds offer relative to many other investments remains relatively high.
We believe high-yield bonds are “priced for perfection.” The current valuations imply a very optimistic outlook, so those low yields and credit spreads means there’s very little wiggle room in case the outlook deteriorates. While the default rate is trending lower, it’s unlikely to fall to zero. High-yield bonds default even in good times and even when economic growth was as strong as it’s expected to be in 2021. With such low compensation for taking that risk, we’d prefer investors favor the higher-rated parts of the market, like those rated “BB” or “B” and limiting exposure to those rated “CCC.” If the tide turns, higher-rated bonds would likely see smaller price declines than those rated “triple C.”
High-yield bond yields still look attractive when duration is considered
Source: Bloomberg, as of 5/31/2021. Indexes used: Bloomberg Barclays U.S. Corporate Bond Index (Investment-Grade Corporates), Bloomberg Barclays U.S. Aggregate Bond Index (U.S. Aggregate Index), Bloomberg Barclays EM USD Aggregate Index (EM Bonds USD), Bloomberg Barclays U.S. Corporate High-Yield Bond Index (High-Yield Corporates), and the Bloomberg Barclays Municipal Bond Index (Municipal Bonds). The yield-to-worst/duration is meant to illustrate how much yield an index offers relative to its average duration, and is measured as a point in time, as of 5/31/2021, and can vary depending on the yield and duration of a security at the time of the investment.
Preferred securities still offer some of the highest yields and coupon rates today, and can serve as a nice complement to a diversified portfolio of fixed income investments. However, investors should:
- Have a long investing time horizon
- Manage total return expectations accordingly. There’s very little room for prices to rise.
Preferreds are a type of hybrid investment that share characteristics of both stock and bonds, but lately they have been driven more by the stock market than the bond market. Given their long maturity dates (or no maturity dates at all), they can be sensitive to changes in long-term Treasury yields, but that hasn’t been the case this year.
The prices of long-term Treasuries have plunged since last August, as the 10-year Treasury yield rose from just 0.5% in August 2020 to over 1.7% in March 2021, but preferred prices have risen over that time frame. Since preferreds are generally “junior” securities, meaning they tend to rank below traditional bonds, they can be highly correlated to the stock market. The rise in the equity markets this year has helped preferreds hold their value.
Preferred prices are up despite the sharp rise in long-term Treasury yields
Source: Bloomberg, using daily data as of 5/31/2021. Bloomberg Barclays U.S. Long Treasury Index (LUTLTRUU Index) and ICE BofA Fixed Rate Preferred Securities Index (P0P1). Past performance is no guarantee of future results.
We believe this trend may continue, albeit with some volatility along the way. While prices could fall if Treasury yields resume their climb higher, there are plenty of factors that should keep their prices supported, like the strong economic backdrop and the steep yield curve. Banks and other financial institutions make up a large share of the preferred market, and a steep yield curve tends to help their bottom lines.
Investors should be wary of the high prices today, however. Going forward, total returns are likely to be driven more by coupon income than by price appreciation. With prices so high, there’s much more room for them to fall than rise. The average price of the ICE BofA Fixed Rate Preferred Securities Index was $106.4 at the end of May, compared to its 20-year high of $108.7.
Bank loans are a niche part of the bond market, but can help investors looking for higher yields today. They are also called senior loans or leveraged loans, and they have some niche characteristics:
- Floating coupon rates
- High-yield, or sub-investment grade, credit ratings
- Collateralized, or secured, but a pledge of the issuer’s assets.
Just like every other investment discussed in this article, bank loan yields are currently low and valuations are expensive. Their floating coupon rates are generally indexed to short-term yields—usually an index that that is highly correlated to the federal funds rate—so the low coupons are likely to remain low until the Federal Reserve begins hiking rates, which isn’t likely to occur until late 2022 at the earliest. While bank loans are riskier than many other types of fixed income investments, their prices should remain supported by all the positive factors already discussed above.
There are two factors that make them worth considering today. First, bank loans have durations of near zero, meaning they have very little interest rate risk. Because their coupons adjust with changing short-term interest rates, their prices don’t need to. If Treasury yields do in fact rise in the second half of the year, bank loan prices might not fall the way bonds with fixed coupon rates might. (Note: They still have high credit risk, given their sub-investment grade ratings.)
Second, because bank loans are secured by a pledge of the issuers’ assets, their prices should fall less than the prices of high-yield bonds if the outlook were to deteriorate or the default rate began to pick up. Bank loans typically have higher recovery rates than traditional high-yield bonds in a default scenario, so that limits the potential price declines, to a degree, if the issuers’ outlook sours.
Like our overall guidance, price appreciation is likely limited. The average price of the S&P/LSTA Leveraged Loan 100 Index is currently $98.2, and it has rarely reached $100.
Bank loan prices are only slightly below $100
Source: Bloomberg, using weekly data as of 5/31/2021. Past performance is no guarantee of future results.
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