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What’s Driving the Strong Returns in Corporate Bonds?

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NATHAN PETERSON: Hello and welcome to the Schwab Market Snapshot for July 12. I’m Nathan Peterson, sitting in for Randy Frederick. Today, I’m joined by Collin Martin, a fixed income strategist from the Schwab Center for Financial Research, who is going to provide us with a mid-year update as it relates to fixed income. Collin, welcome back.
 
COLLIN MARTIN: Hi, Nathan. Thanks for having me back.
 
NATHAN: So, Collin, most fixed-income asset classes had a positive total return in 2017. And in particular, corporate bonds had a relative outperformance when compared to other investments, like U.S. treasuries. What do you think is driving that return in corporate bonds this year?
 
COLLIN: Today, U.S. corporations are generally in good shape. Even though economic growth is still a little low, it’s still positive. And since the recovery began, that’s generally been good enough for U.S. corporations to continue growing their revenues. And we’re starting to see more earnings growth now. After a sluggish couple of years, in the first quarter of this year, S&P 500 earnings saw its best quarterly growth rate since 2011.
 
Easy financial conditions are also supported for U.S. corporations. Now, it may seem counterintuitive that financial conditions are still easy even though the Fed has hiked rates four times since December 2015. But indexes that track financial conditions take other things into account, like credit spreads and the value of the dollar. Now, what’s important is that corporations have generally been able to issue new debt at relatively low interest rates to refinance their existing debt or their maturing debt as it comes due.
 
And, lastly, default rates continue to fall. According to Standard & Poor’s, the trailing 12-month speculative grade default rate dropped to 3.8% in June—down from a peak of over 5% this past December. Now, a key driver of this improvement is the rebound in commodity prices from early 2016. But even when you exclude energy and natural resource issues from the default calculation, that default rate is still very low and well below historical norms. So this has generally been supportive for U.S. corporations and, as a result, corporate bond holders.
 
NATHAN: That’s great. Those are some encouraging factors. So as we look out to the remainder of the year, is it going to be more of the same for corporate bonds?
 
COLLIN: Well, we think it’s going to be difficult for total returns to match the strong first-half performance. In the second half, we think returns will be driven more by coupon payments and less by price appreciation. Now, we don’t think prices will rise too much from here because credit spreads have fallen a lot. Now, a credit spread is the additional yield that a corporate bond offers relative to treasuries and can be thought of as compensation for the additional risk that they have. But because of those supporting factors I mentioned, spreads have fallen, as investors kind of think there’s a little bit less risk in the market today than maybe last year, and that’s pushed prices higher.
 
Now, where we are today, average spreads for both investment grade and high-yield corporate bonds are well below their historical averages and they’re not too far off their post-crisis lows. So we think there’s--you know--very little room for them to fall, which means there’s less room for prices to rise. So even though things are going pretty well for corporations, investors just aren’t really being compensated with additional yield today.
 
We think you can still invest in corporate bonds, but make sure they fit your risk profile. Make sure they fit your strategic long-term goals, and we’d wait for slightly higher yields to kind of boost those allocations a little bit. And, remember, corporate bonds do come with additional risks, especially high-yield corporate bonds. So we would always caution against chasing yield in the riskier parts of the market if your risk tolerance can’t handle it.
 
NATHAN: That makes a lot of sense. Thanks so much for your insights, as always, Collin. And if you want to read more from Collin, you can do so in the Fixed Income section on Schwab.com or you can go to the Twitter handle @SchwabResearch to get more commentary from Collin and other Schwab experts.
 
We’ll be back next week. Until next time, invest wisely. Own your tomorrow.

Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author’s opinions may change, without notice, in reaction to shifting economic, market, business, and other conditions.
Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.
Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.
Schwab Center for Financial Research (“SCFR”) is a division of Charles Schwab & Co., Inc.
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.
Investing involves risk including loss of principal.


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