By Collin Martin
Risks are rising in the corporate fixed income markets and we suggest a more cautious stance heading into 2019.
Investors should consider moving up in credit quality.
Coupon income will likely be a key driver of total returns in 2019.
Risks are rising in the corporate fixed income markets and we suggest a more cautious stance as we enter 2019. Over the next 12 months, we expect volatility to remain elevated and we see risk that credit spreads will widen even further.
While investors don't need to abandon their corporate fixed income holdings, we think a more defensive approach is warranted, and that investors should consider moving up in quality. With a risk of credit spreads widening, we think there's a growing risk of price declines for most corporate fixed income investments in 2019. Coupon income will likely be a key driver of total returns next year.
It's not all bad news, though. High-quality corporate investments have seen their yields rise to the highest level in years, meaning investors can earn higher yields today and still invest in highly rated investments. And for investors with a greater tolerance for risk and a long-term investing horizon, preferred securities have become more attractive.
2018 was a forgettable year for many corporate fixed income investments
Most corporate fixed income investments delivered disappointing total returns in 2018. A combination of rising Treasury yields coupled with rising spreads resulted in lower prices for most fixed income investments. A credit spread is the additional yield a corporate bond offers relative to a comparable Treasury note. Since spreads are a component of yield, rising spreads can push prices lower. The average price of every corporate fixed income index we track is lower today than where it started the year.
Floating-rate investments have eked out positive total returns, while fixed-rate investments have posted losses
Source: Bloomberg. Indexes represented are the Bloomberg Barclays U.S. Treasury Bond Index, Bloomberg Barclays U.S. Corporate Bond Index, Bloomberg Barclays U.S. Corporate High-Yield Bond Index, Bloomberg Barclays U.S. Floating-Rate Notes Index, ICE BofAML Fixed Rate Preferred Securities Index, and the S&P/LSTA Leveraged Loan 100 Total Return Index. Total returns from 12/31/2017 through 12/10/2018. 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.
Floating-rate investments have outperformed those with fixed coupon rates so far this year. Within the investment-grade universe, the Bloomberg Barclays U.S. Floating-Rate Notes Index significantly outperformed the Bloomberg Barclays U.S. Corporate Bond Index. Floaters are significantly less sensitive to rising yields because their coupon rates reset as short-term rates rise. Meanwhile, the average duration of the broad corporate bond index has been rising for years, leaving it very sensitive to rising yields.1
Sub-investment-grade, or high-yield, investments saw a similar trend. Bank loans, which carry below-investment-grade ratings, have outperformed the broad high-yield market as well.
Risks are rising
The risks we see in the corporate bond market continue to rise. Here are a few reasons why we are taking a more cautious approach to corporate investments in 2019:
- The amount of corporate debt outstanding has surged: The size of both the investment-grade and high-yield corporate bond markets has risen sharply over the past decade. With interest rates so low, corporations issued more and more debt, locking in historically low interest expenses. But that debt needs to be retired or refinanced at some point. If refinanced, the interest rates paid on new debt will likely be higher than the debt that's maturating. Rising interest costs can eat into a corporation's earnings and cash flow.
- The rise of the "Triple Bs": Bonds rated in the BBB area - those rated Baa1 through Baa3 by Moody's Investors Services and from BBB+ through BBB- by Standard and Poor's - now make up roughly half of the investment-grade market. That's a twofold risk. First, it means investment-grade corporate bond investors may be taking on more credit risk than they'd like if they are in funds or strategies that passively track an index. Second, downgrade risk poses a threat to the whole corporate bond market. "Triple B" rated bonds not only make up more than half of the investment-grade market, but they are roughly twice the size of the whole high-yield corporate bond market. By nature, the high-yield market has a much smaller investor base than investment-grade corporate bonds, so if a large amount of BBB-rated bonds get downgraded to the high-yield market, that increase in supply could send prices even lower.
A wave of downgrades could have a large impact on the corporate bond market
Source: Bloomberg Barclays Indices. Amounts outstanding as of 12/10/2008 and 12/10/2018. Bloomberg Barclays U.S. Corporate High-Yield Bond Index and the BBB rated subset of the Bloomberg Barclays U.S. Corporate Bond Index.
- Low oil prices: Energy issuers make up roughly 15% of the Bloomberg Barclays U.S. Corporate High-Yield Index, the second highest weight of all sectors. With the price of oil down more than 30% from the 2018 peak hit in early October, this can have an outsized impact on issuers who produce or transport oil. As we saw in late 2015 and early 2016, a big dip in the price of oil can lead to a spike in high-yield spreads and defaults
When oil prices plunged a few years ago, high-yield spreads surged
Source: Bloomberg and the St. Louis Federal Reserve, using weekly data as of 12/7/2018. Crude Oil Prices: West Texas Intermediate (WTI) - Cushing, Oklahoma (DCOILWTICO). 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 guarantee of future results.
- Borrowing costs are rising: In 2018, Treasury yields rose and credit spreads increased, which means it's more expensive for corporations to borrow today. Those higher interest costs can eat into firms' profitability and therefore the ability to service debt.
Investment-grade and high-yield corporate bonds
Relative yields for both investment grade and high-yield corporate bonds have risen sharply since the beginning of October. Rather than chasing the higher yields offered today, we suggest investors maintain a more defensive position, as we expect relative yields could move even higher.
Credit spreads can be thought of as the additional compensation investors earn above the yield on a Treasury security of comparable maturity. There is a higher yield because of the risks that corporate bonds offer, like the risk of default.
Spreads are up over the past few months, but they are still well below previous levels seen over the past eight years or so. With the risks laid out above, we think spreads can modestly move higher next year, pulling prices lower and negatively impacting total returns. We think this risk is greater for the riskier parts of the market, like those with BBB ratings or the high-yield market as a whole.
Spreads are still below previous post-crisis peaks
Source: Bloomberg, using weekly data as of 12/7/2018.
We believe investors who are holding lower-credit-quality bonds should get more defensive with their fixed income investments. For investment grade investors, consider moving up in quality, reducing exposure to BBB rated bonds and into those with ratings of A or above. For bond fund investors, keep in mind that many passive, index-tracking investments will likely have a large exposure to BBBs, so you may want to consider other strategies that take a more active approach and focus on the higher-rated parts of the market.
For high-yield bond investors, make sure your holdings match your risk tolerance. High-yield bonds are risky investments that can suffer large price declines in a short period of time. For instance, in the nine weeks ending December 7, 2018, the average price of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index dropped by 4%.2 If the risk of that type of price decline is too much, consider moving up to higher-rated, intermediate-term bonds.
Preferred securities are relatively attractive today as their prices have fallen to their lowest levels in years.
Preferred securities are a type of hybrid investment that share characteristics of both stocks and bonds. Since they have long maturity dates or no maturity dates at all, they tend to be correlated with long-term Treasury yields, and their prices are very sensitive to rises in long-term interest rates.
So while it might seem counterintuitive to suggest an investment that's highly sensitive to rising interest rates, we don't think long-term yields will rise much further. If we're right that long-term yields may be near their peak, then there's potentially less room for prices to fall. And while this may seem to contrast our view that investment grade and high-yield bond prices may fall further, we think that much of the potential decline with preferred securities has already occurred.
Preferred securities' prices haven't been this low since the beginning of 2014
Source: Bloomberg, using monthly data as of 12/7/2018. Past performance is no guarantee of future results.
Preferred securities do come with high credit risk, however. They generally rank low in a firm's capital structure - most preferreds rank below the issuer's senior unsecured debt. In a default scenario, for example, traditional bondholders are paid before most preferred securities holders. But we see that as less of a risk today given the makeup of the preferred securities market. Financial institutions make up more than 70% of the index. While that sector concentration poses a risk if we encounter a banking crisis, we think most large financial institutions are in relatively good shape today as many firms have cleaned up their balance sheets and reduced their leverage as a result of the 2008-2009 financial crisis.
Preferred securities can help investors earn higher yields today, but they should serve as a complement to a well-diversified fixed income portfolio, not as a substitute. Most importantly, they should be considered long-term investments and are only appropriate for investors who have a greater tolerance for risk as we expect volatility to continue in 2019.
Floating-rate notes and bank loans
Floating-rate investments have been strong performers so far in 2018, with both investment-grade floaters and bank loans outperforming their fixed-rate counterparts. But with the Fed nearing the end of its rate hike cycle, the income upside that floating-rate investments offer will start to fade, and investors may want to consider shifting back into higher-yielding, fixed-rate investments.
A key benefit of floaters is that their coupon rates reset throughout the year. Their coupon rates are generally benchmarked to short-term interest rates, so as short-term interest rates rise, so too do their coupon payments.
We think we're getting closer to the peak federal funds rate of this cycle, however, meaning there may be limited upside to the coupon payments that floaters make. And with this year's rise in Treasury yields, short-term, fixed-rate corporate bonds offer higher yields than most floaters. Investors considering floaters today will, therefore, need the Fed to keep hiking for yields to match the yields that fixed-rate bonds offer, but that might not materialize as planned. And floaters are still issued by corporations, meaning they could be at risk of prices declines if market volatility remains elevated, in-line with our concerns regarding the fixed-rate investment grade corporate bond market.
Bank loans also have floating coupon rates, but they are very different from investment-grade floaters. They are issued by corporations, but they carry sub-investment grade (or "junk") ratings, making them significantly riskier. Junk-rated investments generally have a greater risk of default than those with investment-grade ratings.
Just like the high-yield bond market, bank loan risks are rising. The size of the bank loan market has grown considerably since the end of the financial crisis, and more and more loans are being issued with very few covenants. A bond covenant is a set of terms, defined in the bond's prospectus, which outlines what the issuing firm can or can't do with regard to its debt; without many covenants in place, firms can embark on risky behavior, with very little recourse from their lenders. Even the Fed has issued warnings on the market - in its inaugural Financial Stability Report, it highlighted the low level of yields offered given the risks and noted the deteriorating credit standards.
These risks have begun to manifest themselves lately, resulting in a steep drop in the average price of bank loans. We think prices may continue to fall modestly, and any pause in Fed rate hikes would mean a slower pace of higher coupon resets.
Bank loan prices have fallen sharply since early October
Source: Bloomberg, using daily data as of 12/11/2018.
What to do now
- Move up in credit quality and make sure you are not taking excessive risks in the corporate bond markets.
- Consider preferred securities for higher yields, but make sure you have a long investing horizon to stomach the potential price volatility.
- Begin to shift from floating-rate investments back to fixed-rate investments. As we near the peak federal funds rate of this cycle, there's less room for coupon payments to reset higher.
1 Duration is a measure of interest rate sensitivity; the higher the average duration, the more sensitive the price of a given security or index is to changing interest rates.
2 Price decline from October 3, 2018, through December 7, 2018.