If we take the Fed at its word, interest rates–both short and long term–are likely to remain low for a very long time. While an improving economy and avoidance of the fiscal cliff would allow for some back-up in rates, it may be a long-time before we see a 3% yield on the 10-year yield again, let alone the historic average of 6.2%.
In the interim, yield-hungry investors are faced with a stark choice: accept lower yield or more risk. For those willing to take on marginal risk, we’ve long argued that investors could focus on equity income and fixed income credit risk rather than fixed income duration risk. On the credit side, we continue to believe that both high yield and investment grade bonds may offer good alternatives for investors looking for incremental income.
Credit spreads for investment grade bonds–particularly the lower end of the spectrum–still look attractive. Investment-grade debt has recently exhibited a higher yield premium than was historically the case. In addition, while investment grade bonds are offering a much higher yield than Treasuries, in our view, the default risk on corporate debt remains low.
Despite the slow growth economy, corporate balance sheets remain exemplary with large US companies holding over $2 trillion in cash. As such, we would remain overweight on the iShares IBoxx Investment Grade Corporate Bond Fund (NYSEARCA:LQD), and for investors looking for more targeted positions, we would suggest looking at the iShares Baa – Ba Rated Corporate Bond Fund (BATS:QLTB).
As for high yield bonds, spreads have tightened considerably since the spring. While investment grade spreads have also narrowed, the drop has been far less pronounced. While high yield spreads are now close to their historic average, and seem in line with what you’d expect given the economic climate, investment grade spreads are still wide relative to history.
The wider spread is partially justified by the weak nature of the recovery. Credit spreads are typically wider when economic conditions are poor, as investors demand a higher yield to compensate for the increased default risk. However, even after accounting for the recent softening in most economic data, high yield spreads look wide.
The real culprit for the wide spreads may be the Fed holding down long-term Treasury yields. As long as the current monetary policy continues, fixed-income investors are still faced with the same difficult choice: either accept more risk–in the form of longer duration or more credit exposure–or settle for historically low yields. For those unwilling or unable to settle, investment grade could be one of the better bargains on a risk-adjusted basis.
Disclaimer: Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity. In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility.