by Colin Martin, CFA, Director, Fixed Income, Schwab Center for Financial Research, Charles Schwab and Company, Inc.
Corporate fixed income investments such as corporate bonds and preferred securities had a strong first half this year, outpacing more conservative investments such as Treasuries. They owed that outperformance mainly to price gains.
That raises a dilemma for anyone looking to get into the market now: With prices already high and yields low, such investments appear less attractive today than they were at the start of the year. Further price gains are unlikely, in our opinion.
As a result, we think overall returns aren't likely to be as strong in the second half of the year as they were in the first. That will leave income payments to drive most of the returns in the latter half of the year.
First half returns have been strong for most fixed income investments
The bond market's muted inflation and interest rate expectations seem to be keeping a lid on yields, which peaked early in the year and then headed lower. (When expectations for future inflation are high, yields tend to rise because investors start to demand more yield in exchange for locking money up.) Falling yields are a function of rising prices, and one result of those price gains was that most domestic fixed income indexes we track delivered positive returns during the first half of the year.
Returns from corporate fixed income investments outpaced those from Treasuries in this environment because corporate-related investments generally offer higher coupons to account for their higher risks. As you can see in the chart below, preferred securities performed especially well, as investments with longer maturities tend to see bigger price movements than those with shorter maturities. Preferred securities have long maturities or no maturity date at all.
Corporate-related investments fared well in the first half
Source: Bloomberg. 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, Bloomberg Barclays U.S. Corporate High-Yield Bond Index, BofA Merrill Lynch Fixed Rate Preferred Securities Index, Bloomberg Barclays Municipal Bond Index, Bloomberg Barclays U.S. Floating-Rate Note Index, and the S&P/LSTA Leveraged Loan Total Return Index. Total returns from 12/31/2016 through 6/27/2017. 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.
Corporate valuations are now a bit stretched
We see little room for prices of corporate-related investments to rise relative to U.S. Treasuries in the second half, so our outlook on corporate bonds is relatively neutral.
Again, corporate-related fixed income investments generally offer higher yields than Treasuries because they tend to be riskier. How much extra yield—known as the credit spread—is a key factor to consider when investing in corporate-related fixed income investments.
At this point, spreads are relatively narrow and don’t have much room to narrow further. That means the higher coupon payments that corporate investments offer will likely be a key driver of total returns the rest of the year.
The average option-adjusted spread (OAS) of the Bloomberg Barclays U.S. Corporate Bond Index is now at 1.10% (the index is a benchmark for the investment grade corporate bond market). That’s well below the long-term average of 1.6%, and not too far off from the post-crisis low of 0.97%, reached in May 2014.
Spreads have tightened even more in the high-yield market. The average OAS of the Bloomberg Barclays U.S. Corporate High-Yield Index is just 3.69%, well below the long-term average of 5.5%.
If spreads were to widen out a bit, tactical-minded investors could use it as an opportunity to bump up their exposure to either investment-grade or high-yield corporate bonds versus Treasuries. For now, we think investors should stick with their long-term strategic allocations to both.
High-yield spreads are back near their recent lows
Source: Bloomberg. Daily data as of 6/27/17. 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.
Prices are likely to find support
If we don’t expect prices to rise much further, we also don’t expect them to fall much, at least in the near term. A falling default rate and still relatively favorable borrowing conditions, despite the recent Federal Reserve interest rate hikes, are both factors that could support prices.
While rising defaults in the energy sector of the high-yield market made headlines in 2016, the default rate has been falling sharply lately. According to Standard and Poor’s, the trailing 12-month speculative-grade default rate fell to 3.6% in May, marking the fifth straight monthly decline and down from 5.1% in December. Removing energy and natural resource issues from the calculation brings the default rate down to just 1.8%, the lowest reading in more than a year. S&P expects the trend to continue, with the default rate falling to 3.3% by March 2018.1
Excluding energy and natural resources issues, the default rate remains very low
Source: Standard and Poor’s Trailing 12-Month Speculative-Grade Corporate Default Rate, May 2017. S&P conducts its default studies on the basis of groupings called static pools. For the purpose of the study, S&P forms static pools by grouping issuers by rating category at the beginning of each year that the CreditPro database covers. Each static pool is followed from that point forward. All companies included in the study are assigned to one or more static pools. When an issuer defaults, S&P assigns that default all the way back to all of the static pools to which the issuer belonged. S&P calculates annual default rates for each static pool, first in units and later as percentages with respect to the number of issuers in each rating category.
And although the Fed has raised its benchmark interest-rate range three times since December 2016 (and four times since December 2015), the rate is still near all-time lows. Normally, when financial conditions tighten, companies may find it harder to access the credit markets and refinance debt. That hasn’t been the case so far in this rate cycle. In fact, financial conditions have eased in the face of the rate hikes, making it easier for businesses to continue issuing low-yielding debt at historically low rates. Going back to 1980, there has never been a recession in the 12 months following a period when financial conditions have been this easy. Positive, albeit slow, growth should continue to support corporations’ ability to service their debts.
What could go wrong?
We do see a few risks that could affect the corporate bond market.
For example, a drop in oil prices could rattle the high-yield market. Energy issues make up nearly 13% of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index. Prices of oil and other commodities have been falling, with the price of West Texas Intermediate oil now down more than 20% from February’s 2017 high.2 A further decline could shake the market.
That said, we wouldn’t expect a repeat of the high-yield bond sell-off of late 2015 and early 2016, because many energy companies have become more efficient and can better handle today’s lower prices. And a study backed by the U.S. Energy Information Administration found that drilling and completion costs are likely to fall, which could take more pressure off energy companies.3
In our opinion, a more long-term risk to corporate bondholders is the health of U.S. corporations’ balance sheets and earnings. Corporate debt continues to rise, and we’re concerned that much of that debt has gone to shareholder-friendly activities like dividends and stock-buybacks rather than funding growth through capital expenditures. While debt outstanding has jumped, aggregate liquid assets haven’t risen by much. This is troubling for corporate bondholders because the gap between what’s owed to lenders and the assets available to pay those lenders has widened. Down the road, this could lead to more corporate defaults.
Rise in corporate borrowings has far outpaced liquid asset growth over the past decade
Source: Federal Reserve Flow of Funds Report. Quarterly data, as of Q1 2017. Corporate liquid assets are represented by nonfinancial corporate business foreign deposits, checkable deposits and currency, time and savings deposits, money market fund shares, security repurchase agreements, debt securities, and mutual fund shares.
Preferred securities: high prices and declining coupons
Preferred securities’ strong first-half performance also leaves them with less room to rise in the second half.
Preferred securities are a type of hybrid investment that have characteristics of both stocks and bonds. As mentioned above, they have long maturities, or no maturity dates at all, so their prices tend to be more sensitive to changing interest rates than traditional corporate bonds. As the 10-year Treasury yield has fallen more than a quarter of a percent this year, preferred prices have risen accordingly. In fact, the average price of the BofA Merrill Lynch Fixed Rate Preferred Securities Index, at $105.60, isn’t too far off the post-crisis high of $107.50, when long-term Treasury yields were much lower than they are today.4
Meanwhile, preferreds’ coupon rates continue to fall as many issuers have taken advantage of the drop in yields by retiring their higher-coupon issues and replacing them with lower-coupon issues. Most preferred securities are callable, meaning the issuer may redeem the security at a set price on or after a specific date prior to maturity. As yields fall, issuers may “call in” their outstanding issues, usually at the $25 par value, which can limit the potential for price appreciation.
At 5.9%, the average coupon rate of the index has fallen sharply over the past few decades, but the drop over the past four years has been even more pronounced.
Preferred coupon rates have fallen sharply over the past four years
Source: Bloomberg. Monthly data as of 6/23/2017.
Preferred securities can still make sense for long-term investors looking for higher income, but the declining trend in coupon payments and limited upside means that some caution is warranted over short time horizons because their prices tend to be more volatile than traditional fixed income investments.
Floating-rate investments can continue to benefit from Fed rate hikes
While rising interest rates tend to hurt traditional bond prices, investments with floating coupon rates may actually benefit from future Fed rate hikes. The Fed said in June that it sees one more rate hike later this year, followed by three more quarter-point increases in 2018.
Investment-grade floating-rate notes, or floaters, are a type of corporate debt whose coupon rate is based off a short-term benchmark—usually the three-month London Interbank Offered Rate (LIBOR)—plus a spread. The spread is like the credit spread mentioned earlier and is offered to investors to compensate for the additional risk of investing in corporate bonds. Three-month LIBOR is highly correlated to the federal funds rate, so as the Fed continues to raise rates, the coupon rates on floaters should continue to rise as well. Another benefit of investment grade floaters is that their prices tend to be relatively stable even when short-term rates rise. But they still have credit risk and can see their prices drop during periods of market distress.
Bank loans are another type of floating-rate investment, but they are very different from investment-grade floaters. Bank loans are private transactions (unlike bonds that trade over-the-counter) that have sub-investment grade ratings, and are relatively illiquid. Due to their low credit ratings, bank loans should always be considered aggressive investments.
The coupon rates on bank loans are also based on three-month LIBOR plus a spread, but the spread for bank loans tends to be higher than those for investment-grade floaters due to the higher credit risk. Their coupons should also increase as the Fed continues hiking rates, but their prices tend to be much more volatile than investment-grade floaters. We see little room for bank loan prices to rise, on average, in the second half of the year, but the potential for coupon payments to rise make them relatively attractive today. However, due to the risks involved, bank loans should be considered a complement to, not a substitute for, core bond holdings.
What to do now
Stick with your long-term allocations to the corporate-related parts of the fixed income market. Valuations appear a bit stretched and we see little room for price appreciation. Income payments, rather than higher prices, will likely be a key driver of total returns in the second half of the year. For investors worried about the effects of higher short-term interest rates, investments with floating coupons rates can help balance that risk.
1 “The U.S. Corporate Speculative-Grade Default Rate is Expected to Fall to 3.3% by March 2018,” Standard and Poor’s, June 2, 2017
2 Source: Bloomberg. Generic 1st Crude Oil, WTI. Price change from 2/23/2017 through 6/21/2017.
3 “Trends in U.S. Oil and Natural Gas Upstream Costs,” U.S. Energy Information Administration, March 23, 2016
4 Average price as of 6/23/2017
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Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.
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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Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.
Preferred securities are often callable, meaning the issuing company may redeem the security at a certain price after a certain date. Such call features may affect yield. Preferred securities generally have lower credit ratings and a lower claim to assets than the issuer's individual bonds. Like bonds, prices of preferred securities tend to move inversely with interest rates, so they are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and preferred securities, when sold before maturity, may be worth more or less than original cost. Preferred securities are subject to various other risks including changes in interest rates and credit quality, default risks, market valuations, liquidity, prepayments, early redemption, deferral risk, corporate events, tax ramifications, and other factors.
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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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