A Challenging Start to the Year for Investment Grade Corporate Bonds
Despite somewhat stable credit spreads, the rates sell-off in 2018 is causing investment grade corporate bond total returns to have the worst start to a year in two decades, as you can see from this week’s chart. The Bloomberg Barclays U.S. Investment Grade Corporate Index option adjusted spread is only about two basis points (bps) wider year-to-date (YTD) through February. Similarly, excluding the recession years of 2002 and 2008, high yield YTD total returns are the second worst for the asset class over the same time period.
Although corporate bond total returns have been weak, they are in line with those in previous rising rate environments. During historical occurrences of gradual interest rate increases, spreads have broadly traded tighter as the yields for investors remain attractive. In addition, analyzing total returns over longer time periods of gradually rising rates demonstrates that the initial lowering of prices is stabilized by the combined effect of tighter spreads, roll down and carry. Given the relatively flat yield curve, roll down is a less significant contributor to positive returns. The 2- to 10-year Treasury curve has flattened from over 250 bps in early 2014 to the low 60s. The carry component will become more meaningful, as any new issuance printed will have higher coupons.
There are also supportive technicals in the market that argue for firmer or tighter spreads. In 2018, owners of investment grade corporate bonds will receive an average of $80 billion per month from coupon payments and maturities. In February, net corporate issuance was a meager $9 billion; this is significantly low when you consider there have only been two months in the past five years when investment grade net supply has been negative in a month. Light supply in the near term can be attributed to tax reform, which has limited supply from companies with cash overseas, little M&A funding in the near term and higher rates leading some potential issuers to reassess capital needs. Gross YTD investment grade supply is down about 20% year over year. While this is light, most forecasts will be comfortably short of last year’s record issuance. In 2018, coupon and maturity payments are meaningfully higher in the first half than later in the year (over $100 billion each of the next few months) and should be supportive of a firm bid for credit.
With further Federal Reserve policy expected to continue along the tightening path, the combined effect of carry and firm spreads should allow for some stability in bond returns over the near term. The strong economic backdrop and encouraging earnings from companies broadly, as well as very supportive technicals, is a positive for credit spreads. But key to the extent of any stability is the gradual nature of a rate rise. If moves in interest rates become more violent and are accompanied by broad market volatility, it will make any recovery or firmness in corporate bond performance a greater challenge.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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