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Is There a Corporate Bond Bubble?

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COLLIN MARTIN: Over the past decade, there’s been a boom in the amount of corporate bonds outstanding. With interest rates so low, corporations have issued more and more debt, taking advantage of record-low borrowing costs, and now there’s some concern that this could lead to some sort of corporate bond bubble that might soon burst. I’m Collin Martin, and this is Bond Market Today.

Let’s start with the basics about corporate bonds. They’re simply a type of bond issued by corporations as a way to raise capital. Like most bonds, they come with a promise to pay timely interest payments on that principal amount, and the borrower promises to make that principal payment at maturity, barring a default, of course.

Now, over the past decade the amount of investment-grade corporate bonds outstanding has more than doubled, and as a percent of GDP, total US non-financial corporate debt has surpassed the peak hit in 2009, and that ratio continues to rise.

Now, this surge is likely due to the low interest rate environment. Corporations have taken advantage of the low yields to refinance some of their higher-yielding debt with now lower-yielding debt, and they’ve issued more and more long-term debt so they can lock in those low yields for years. Now, this is a risk because at some point that debt needs to be repaid, and that can be a problem come the next economic downturn.

Now, given those risks, we don’t think we’re going to see a sudden burst anytime soon, for lack of a better term. There are some positives in the corporate bond market. Cash balances remain high, liquid assets on balance sheets remain high, and corporate profits remain strong. And despite the Fed hiking rates over the past few years, financial conditions remain relatively easy.

Now, even though we don’t think corporate bond prices are going to fall sharply any time soon, we do think there are things that investors can do to combat some of these concerns. The first is to watch your average credit rating. In the investment-grade corporate bond market, triple-B-rated issues have made up a growing share. Triple-B is the lowest rung of the investment-grade ladder. So if you’re tracking an index or you’re in some sort of strategy that tracks an index, you might be holding more of these lower-rated investment-grade corporate bonds than anticipated, so you might want to start focusing on some slightly higher credit ratings. The second thing you can do is watch your average maturity. As corporations have issued more and more long-term debt, the average maturity of the investment-grade corporate bond market has risen as well. And all else being equal, longer maturities mean higher interest rate risk, and that means larger price declines if interest rates do continue to rise. Since we do think interest rates will continue to rise at least modestly, you might want to lower the average maturity of your holdings, probably a little below what the average maturity of the index is, so you can help limit those declines.

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Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

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The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar (USD)-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services. This index is part of the Bloomberg Barclays U.S. Aggregate Bond Index (Agg).

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