RANDY FREDERICK: In their mid-March meeting, the Federal Open Market Committee raised interest rates for the third time since the financial crisis. Collin Martin, a fixed income strategist at the Schwab Center for Financial Research, joins me for the March 21 Schwab Market Snapshot to discuss why yields are still so low across all segments of the bond market. Welcome back, Collin.
COLLIN MARTIN: Hi, Randy. Thanks for having me back.
RANDY: So, Collin, last week’s rate hike from the Fed was the second rate hike in only three months. And yet it seems like yields are still really low for all different types of bonds. So what do bond investors need to know right now, especially about the more risky parts of the bond market?
COLLIN: For investors considering the riskier parts of the market, we think it’s best to manage expectations. We don’t think returns going forward are likely to be as strong as they’ve been recently. For example, in 2016, both investment-grade and high-yield corporate bonds were some of the best fixed income performers, with some high-yield indices posting total returns of over 17%. Now, a key driver of those strong returns was the drop in yields relative to Treasuries. Because bond yields and prices move in opposite directions, that pushed prices higher. Now, that yield differential is called a credit spread. It’s the additional yield that corporate investors get relative to Treasuries, and it’s like a risk premium. You know, you get extra yield for taking on the extra risk of investing in a corporate bond, like the risk of default. Now, they’ve been falling for a while and they fell very sharply in 2016 through today. In fact, they’re well below their long-term averages and they’re not too far off the post-crisis lows reached in 2014. So with less room for yield spreads to fall, we don’t think there is much room for price appreciation relative to Treasuries.
RANDY: Now, if corporate bond prices are up, it must mean that investors are buying up the corporate bonds. In other words, if they’re willing to accept lower yields, it must mean that the outlook for corporate bonds has gotten a lot better, right?
COLLIN: That’s right. Credit spreads usually fall for good reasons. Now, one of the good reasons we’re seeing right now is earnings growth. After years of low or even negative earnings growth, the picture is a bit more positive in 2017. And that’s good for bond-holders because stronger earnings makes it a little bit easier for issuers to make timely interest and principal payments. Now, another positive thing we’re seeing is a small drop in the default rate. According to Standard & Poor’s, the trailing 12-month high-yield default rate dropped to 4.4% in February. That was down from 5.1% in December, which was a post-crisis high. So that’s another support for the corporate bond market. And if we do get some expansive fiscal policies from the new administration, that should generally support corporations, as would a corporate tax cut.
So there are supports for corporate bonds today, but like I said earlier, you know, the price that you invest in does matter. And with yields relatively low today, we don’t see much room for price appreciation. We think coupon income will likely be a key driver going forward. You know, if you are considering investment-grade or high-yield bonds, we always think it’s important to make sure that those investments match your risk tolerance, your investing goals, and your time horizon. We always caution against reaching for yield in investments if they don’t match your risk tolerance.
RANDY: Well, that’s about all the time we have for today, Collin. That is great information. Thank you for that.
And, listen; if you want to read more from Collin, you can do that in the Fixed Income section of Schwab.com. And don’t forget, you can follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely. Own your tomorrow.