Investment-Grade Corporate Bonds Delivering Strong Returns

Key Points

  • Falling Treasury yields have helped push the total return on the Barclays U.S. Corporate Bond Index to 6.6% so far this year, above most other types of fixed-income investments.
  • Although yields on investment-grade bonds have fallen, their spreads compared to Treasuries are near the historical median, making them fairly valued, in our view.
  • Despite the relatively low yields, we still think investment-grade corporate bonds offer an attractive yield relative to Treasuries.

After a disappointing 2013, investment-grade corporate bonds are once again delivering positive returns, thanks mainly to price gains linked to falling Treasury yields. And although yields on investment-grade corporate bonds are now near all-time lows, we still think they look attractive relative to Treasuries and make sense for investors looking to generate income without incurring too much risk.

Positive total returns

The Barclays U.S. Corporate Bond Index has generated a total return of 6.6% this year—a nice improvement from its 1.5% drop in 2013. In fact, investment-grade corporate bonds have performed better than most other types of fixed income investments this year, including sub-investment-grade bonds, as you can see in the chart below.

 

Investment-grade corporate bonds have posted strong year-to-date total returns

Investment-grade corporate bonds have posted strong year-to-date total returns

Source: Barclays. Year-to-date total returns as of August 25, 2014. Barclays U.S. Aggregate Bond Index, Barclays U.S. Treasury Bond Index, Barclays U.S. Corporate Bond Index, Barclays U.S. Corporate High Yield Bond Index, Barclays U.S. Mortgage-Backed Securities Index, Barclays Global Aggregate ex U.S. Bond Index. Returns assume reinvestment of interest and capital gains. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

 

We think the recovery in corporate bond returns mainly reflects a decline in Treasury yields (the yield on the 10-year Treasury was at 2.38% on August 25, down from 3.03% at the end of 2013). With a few exceptions, investment-grade corporate bond yields have tended to move in tandem with Treasury yields. When bond yields fall, prices rise—and rising prices mean higher total returns. Although corporate bond yields have fallen, creating a dilemma for income-focused investors, we still think they look more attractive than Treasuries.

How do spreads look?

Because of the increased risks associated with corporate bonds, their yields are higher than those on comparable Treasuries. The difference is known as the credit spread.

The average option-adjusted spread of the Barclays U.S. Corporate Bond Index was 1.01% on August 25, below the average of recent decades. Since 1989, when the index started tracking spread data, the average spread has been 1.3%, almost 30 basis points higher than its current level.

The lower the spread, the smaller the yield premium investors receive relative to what they would get from lower-risk Treasuries. Because spreads are below their historical average, one might get the impression that corporate bonds are overvalued. However, we still think they make sense.

For one thing, the market disruptions of the past 10-15 years have tended to inflate the long-term spread average. If we exclude those periods, spreads generally tend to hover in tight ranges. Looking at the median historical spread for the period can help weed out such distortions. Since 1989, the median option-adjusted spread of the Barclays U.S. Corporate Bond Index has been 1.03%, very close to where it is today, which makes investment-grade corporate bond valuations look more appropriate.

Where are spreads headed?

We can review historical data to determine how much time average spreads have spent below their current level of about 1% to gain some sense of their behavior. Based on month-end data, the average option-adjusted spread of the Barclays U.S. Corporate Bond Index has hovered below that level nearly half (47%) the time since 1989.

Investment-grade corporate bond spreads tend to trade in tight ranges

 Investment-grade corporate bond spreads tend to trade in tight ranges

Source: Barclays. Monthly data as of August 25, 2014. Option-adjusted spread is a method used in calculating the relative value of a fixed income security containing an embedded option, such as the borrower’s option to prepay the loan. When we reference a “credit spread” for a corporate bond index, we are referencing the option-adjusted spread.

 

Before the last financial crisis, spreads were as low as 0.85% in early 2007, and now we don’t think there’s much room for them to fall from their current level. However, they’ve historically stayed below 1% roughly half the time, and it’s possible they could remain in their current low range for several months, or even years. While this may mean prices aren’t likely to rise much further, we also see less downside risk compared to other fixed-income investments, especially sub-investment-grade bonds.

The average option-adjusted spread on the Barclays U.S. Corporate High-Yield Bond Index is around 3.6%—below its 20-year average of 5.3%—meaning investors are getting less than average compensation for the risks associated with this part of the bond market. We think investors who have been reaching for yield from sub-investment-grade bonds should consider moving up in quality to investment-grade corporate bonds.

What to do now

We believe intermediate-term investment-grade bonds make the most sense right now, especially for investors who have been reaching for yield in the lower-rated segments of the fixed-income market.

Short-term bond yields are still very low and in our view will likely rise as we get closer to the first Federal Reserve interest rate hike, expected sometime next year. And with the 10-year Treasury bond currently offering a yield of 2.38%, we think investors would be better off waiting for more attractive entry points on the long end of the yield curve. We also think investors can consider beginning to add a little duration to their fixed income portfolios when the 10-year Treasury approaches 3%; until then, we prefer intermediate-term bonds.

For investors who hold individual bonds, we think a portfolio that diversifies among various sectors is appropriate. Spreads for each sector have converged over the past few years

Spreads for each sector have converged over the past few years

Source: Barclays. Monthly data as of August 25, 2014. Data shown represents the Industrials, Utilities, and Financials sub-indices of the Barclays U.S. Corporate Bond Index.

Investment-grade corporate bonds are usually broken down by three broad sectors: utilities, industrials and financial institutions. Today, the average option-adjusted spreads of each sector are all very similar, meaning it’s difficult to find one sector that offers a significantly higher yield.

 

Source: http://www.schwab.com/public/schwab/nn/articles/Investment-Grade-Corporate-Bonds-Delivering-Strong-Returns?utm_source=Triggermail&utm_medium=email&utm_term=Financial%20Advisor%20Insights&utm_campaign=Post%20Blast%20%28wealthadvisor%29%3A%20FINANCIAL%20ADVISOR%20INSIGHTS%3A%20Tons%20Of%20Investors%20Seeking%20Advisors%20Are%20Confused%20About%20Some%20Pretty%20Basic%20Stuff

Disclosure: This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional investment, legal, tax, or accounting counsel.

 

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