Investment-grade corporate bond prices have dropped sharply over the past few weeks, weighing on the broad domestic bond market.
Investors looking for income and who have a long-term investing horizon may want to consider investment-grade corporate bonds now, but we still suggest focusing on those with ratings of “A” or above.
We think prices can still fall further, but the announcement of investment-grade corporate bond purchases by the Federal Reserve may provide some level of support.
Investment-grade corporate bonds—often considered high-quality fixed income investments—have been hit hard lately, and their prices have fallen sharply in just a matter of weeks. Unfortunately, we don’t believe a sharp reversal in prices is likely in the near term. However, we think investment-grade corporate bonds can still make sense for investors who are looking for higher yields today and are willing to ride out the volatility that may continue.
Below we’ll discuss what has been driving performance lately and what investors need to know now, including those investors who are in or nearing retirement who hold investment-grade corporate bonds for the higher yields they typically offer compared with Treasuries.
Corporate bond returns have dropped
The sharp drop in the value of investment-grade corporate bonds might have caught many investors off guard, especially given the sharp drop in Treasury yields this year. One of the basic tenets of bond investing is that bond prices and yields move in opposite directions. With Treasury yields falling (and their prices rising), why are investment-grade corporate bonds suffering?
Investment-grade corporate bonds have credit risk, which means the risk that the issuer might not be able to make timely interest or principal payments. That risk has come front and center due the threat of COVID-19 and its impact on the overall economy, and it has especially weighed on the outlook for corporate profits.
As a result, the prices of corporate bonds have fallen sharply—some more than others. As the chart below illustrates, corporate bonds at the lowest rung of the investment-grade spectrum—those with “Baa” ratings—have posted the largest losses.1 While the “Aaa” index has posted a positive total return, that sub-index comprises less than 2% of the Bloomberg Barclays U.S. Corporate Bond Index, as there are only two domestic corporate issuers that still maintain “triple A” ratings.2
The drop in corporate bond values has weighed on the performance of the Bloomberg Barclays U.S. Aggregate Bond Index, often considered the benchmark for the domestic bond market. Investment-grade corporate bonds currently make about 22% of the Aggregate index.
“A” and “Baa” corporate bond returns have weighed on the broad market
Source: Bloomberg. Total returns from 12/31/2019 through 3/25/2020. Indexes represented are the Bloomberg Barclays U.S. Aggregate Bond Index, Bloomberg Barclays U.S. Treasury Bond Index, Bloomberg Barclays U.S. Corporate Bond Index, and the “Aaa”, “Aa”, “A” and “Baa” sub-indexes of the corporate bond index. 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 has driven the poor performance?
We believe there are three reasons for the drop in corporate bond prices lately:
1. Corporate profit concerns. Deteriorating corporate fundamentals were a key reason why we suggested a cautious approach to the corporate bond market in 2020. Corporate profit growth has generally stalled during the past few years, and corporate profits are now widely expected to decline sharply due to the economic impact of COVID-19.
On the bright side, corporate bond interest payments are guaranteed by the issuer, barring a default, so corporations have strong incentives to make those interest payments. However, a prolonged economic downturn and a sharp drop in corporate cash flows will likely make it difficult for many corporations to service their debt.
2. Liquidity. Given the market volatility over the past few weeks, many investors rushed for the exits of most non-Treasury-related investments. In the week ending March 18, 2020, investors pulled more than $35 billion from U.S. investment-grade corporate bond funds. That exceeded the previous record one-week outflow, $7.3 billion, set just one week earlier.3
As investors withdraw their money from funds, the fund managers likely have to sell many of their holdings to meet those redemptions. This selling pressure likely sent corporate bond prices even lower, and resulted in the prices of many corporate bond exchange-traded funds (ETFs) trading at discounts to their net asset values.
While liquidity may remain an issue given the market volatility, the Federal Reserve has taken many steps—including announcing its intention to buy investment-grade corporate bond ETFs—that are aimed at keeping the corporate bond markets functioning properly.4
3. “Fallen-angel” risk. A fallen angel is a bond that initially carried an investment-grade rating, but was then downgraded to high-yield, or “junk,” status.
Corporate bonds with “Baa” ratings now make up roughly half of the Bloomberg Barclays U.S. Corporate Bond Index. With so many bonds at the lowest rungs of the investment-grade spectrum, there’s no shortage of fallen-angel candidates these days.
The large amount of “Baa” corporate bonds outstanding doesn’t necessarily mean all will suddenly get downgraded to junk status, however. A “Baa” rating is a general rating, and, using the rating scale from Moody’s Investors Services, there are additional numeric qualifiers: Baa1, Baa2 and Baa3. As the chart below illustrates, a little more than $600 billion in corporate bonds have a composite rating of Baa3. While multi-notch downgrades can’t be ruled out, the most likely fallen angels are those bonds with Baa3 ratings.
There are fewer “Baa3” bonds than those with “Baa1” and “Baa2” ratings
Source: Bloomberg, as of 3/19/2020. Columns represent the total amount outstanding of the issues within the Bloomberg Barclays Baa Corporate Total Return Index Value Unhedged (LCB1TRUU) using “Bloomberg Composite Rating” for each issue, but translated to the Moody’s Investors Services rating scale for consistency.
Different corporate bond sectors are at greater risk of having their components downgraded to junk territory, as well. As the chart below illustrates, the Information Technology, Energy, and Consumer Discretionary sectors have the greatest proportion of bonds at the lowest rung of the investment-grade ladder. Meanwhile, Communication Services, Utilities, and Consumer Staples sectors have the lowest weighting of “Baa3” issues.
Weighting of “Baa3” issues by sector
Source: Bloomberg, as of 3/19/2020. Bloomberg Barclays Baa Corporate Total Return Index Value Unhedged (LCB1TRUU). Columns represent the weight of “Baa3” rated issues for each sector as a percent of the broad “Baa” corporate bond index. Note that sector names provided by Bloomberg have been re-mapped to be consistent with Global Industry Classification Standards (GICS) sectors.
Relative yields have surged
One way we evaluate the corporate bond market is by looking at credit spreads. A credit spread is the additional yield that a corporate bond offers relative to a Treasury security with a comparable maturity. The spread is meant to compensate investors for the additional risks that come with corporate bonds, like the risk of default.
Credit spreads have surged to levels not seen since the 2008-2009 financial crisis. The average option-adjusted spread (OAS) of the Bloomberg Barclays U.S. Corporate Bond Index closed at 3.7% on March 23, 2020, the highest level since the financial crisis, before dropping to 3.2% on March 25.
Given the higher relative yields today, investment-grade corporate bonds appear more attractive to us for investors looking for higher yields today. We’d caution that spreads can move higher, however—meaning the value of investment-grade corporate bonds could fall even lower if the economic outlook continues to deteriorate.
We do think any further rise in spread (or drop in prices) may be limited due to a combination of the Federal Reserve’s willingness to buy investment-grade corporate bonds in both the primary and secondary markets, as well as the potential aid of nearly $500 billion that was included in the stimulus bill recently passed by the Senate. Both of these might keep investment-grade corporate bond prices better-supported than they would have been otherwise.
Spreads are at their highest levels since the financial crisis
Source: Bloomberg, using weekly data as of 3/25/2020. 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. Past performance is no indication of future results.
What to do now?
We still believe that investment-grade corporate bonds can play an important role in most investors’ portfolios—especially those in or near retirement who rely on the income payments they provide. We believe that prices are likely to remain volatile and additional price declines are possible. Here are a few things to consider:
1. Consider investment-grade corporate bonds for the yields they offer, not for near-term price appreciation. We think prices may move modestly lower, and once stabilized, we don’t necessarily expect a sharp, v-shaped recovery. At over 4%, the average yield-to-worst of the Bloomberg Barclays U.S. Corporate Bond Index is still near at its highest level over the last 10 years.
2. Continue to move up in credit quality. We still favor credit ratings of A or above. That may be difficult for investors who use mutual funds or ETFs, given that Baa rated bonds make up roughly half of the index, but there are some funds (active or passive) that have tilts towards higher credit ratings. For those looking for bond funds, you can explore the Mutual Fund OneSource Select List or the ETF Select List and look for those under the “corporate bond” category.
3. For those who hold individual bonds, we still suggest moving up in credit quality. We believe that many Baa rated corporate bonds will be downgraded to junk—especially those that already have a negative outlook or are on negative credit watch.5 Once an issuer is likely to be downgraded to junk, its bond prices tend to fall in value, and they may fall even more once that downgrade actually occurs. For many investors, junk-rated issues won’t necessarily be in line with their risk tolerance.
4. If you’re considering investment-grade corporate bonds today, you may want to use dollar-cost averaging to increase your exposure. By investing the same dollar amount at regular intervals over time, dollar-cost averaging can help you buy more securities when prices are lower and fewer when prices are higher. Given the market volatility and uncertain outlook, we don’t think it’s appropriate to be making large portfolio shifts today.
1 For this article, we use the ratings scale from Moody’s Investor Services, which is as follows: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, and Baa3.
2 While there are only two U.S. corporations in the “Aaa” component of the Bloomberg Barclays U.S. Corporate Bond Index, it also includes Aaa rated taxable bonds issued by other entities like U.S. universities.
3 Source: Bloomberg, “High-Grade Bond-Fund Outflows Hit $35.6 Billion, Smashing Record,” March 19, 2020
4 Source: Federal Reserve, “Federal Reserve announces extensive new measures to support the economy,” March 23, 2020.
5 In addition to actual credit ratings, the rating agencies also issue outlooks (positive, stable, negative) for the issuer which are meant to assess the potential direction of a credit rating over the intermediate term (six months to two years), while ratings on credit watch indicate a more short-term change in a credit rating.
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