INSIGHTS

On November 20, 2017

AAM Viewpoints – Corporate Bonds; a Recent Pullback But Still on a Roll in 2017

Corporate bonds have had a great run in the 22 months since the low experienced in those “worst first six weeks of the year ever” in 2016. The BofA (Bank of America)/Merrill Lynch US Corporate Index for all U.S. Investment Grade Corporate bonds returned 11.4% in that period. A-Rated bonds 8.5%. BBB rated bonds 15.5%. BB rated bonds 23.9%. All High Yield according the BofA/Merrill Lynch High Yield Index, 30.4%. Today some investors wonder if they’ve run too far, too fast. Starting in November High Yield finally went the other way; index prices dropped 1.4% in the first half of November. The Investment Grade US Corporate Index prices fell less than 0.2% indicting that the pullback was more due to credit concerns of High Yield rather than a concern of higher interest rates in the short term. Nevertheless, at the end of October Investment Grade bonds had reached the tightest spread to U.S. Treasuries they had seen since 2007. High Yield wasn’t far behind. Can the market justify these levels?

With equity markets still near all-time highs and corporate bond default rates near historical lows it is logical for credit spreads (the amount corporate bonds pay above “risk free” U.S. Treasury bond yields) to be smaller than average. While the credit spreads are at near term lows, Investment Grade Corporate bonds had even lower credit spreads from the end of 2003 to the middle of 2007, at a time when the 10-year U.S. Treasury yield ranged between 4% - 5%, more than double today’s recent yield levels. The premium above Treasury yields that corporate bonds pay today is still a noticeably higher percentage than it was in the 2004-2007 period; 40% higher today verses 20% above U.S. Treasury rates during 2004-2007. Bond prices can continue to trade higher from here without setting new records for low credit spreads. If stocks continue to trade higher bonds are likely to follow in that direction.

A closer look at corporate bonds finds spread compression between the different ratings categories. Since February 2016 when yield differentials were at their recent widest, the spread between A-rated and BBB-rated corporate bonds has tightened 86 basis points (bps), and at 59bps is currently below the 89bps six-year average. At the same time the spread between BBB’s and BB’s rated bonds fell 154 bps to 82bps, also well below its 113bps six-year average. Current absolute yield levels find A-rated bonds yielding 21bps more than their 2.81% six-year average. BBB’s are 9bps lower than their six-year average yield of 3.70%, and BB’s are 42bps below their average of 4.84%. These yield levels indicate BB’s are somewhat expensive right now, BBB’s reasonably valued, and A’s slightly cheap. On the next significant market correction it is likely that there will be a revision towards the mean in spreads which will see BB’s relatively underperforming BBB’s and A’s modestly outperforming.

While bonds may continue to underperform stocks as they have for quite some time now, we believe they have the potential to return more than their coupon in 2017, which could easily beats money market rates, and continue to offer good risk diversification for portfolios heavily weighted in equities.

CRN: 2017-1106-6245R

AAM is not affiliated with Dial Capital Management and was not involved in the preparation of this article. The opinions expressed herein are solely those of Dial Capital Management and do not necessarily reflect those of AAM.