INSIGHTS

On February 15, 2018

Corporate Bonds: A Review of 2017 and a Look Forward into 2018

Review of 2017:

Corporate bonds delivered solid returns to fixed income investors in 2017. The Bank of America/Merrill Lynch U.S. Corp Index posted a total return of 6.48%, the best return since 2014. Within the Index, the two largest rated sectors, single-A rated bonds (44% of Index market value) and BBB rated bonds (48%) dominated the returns. The more interest sensitive A-Rated returned 5.82% underperforming the more credit sensitive BBB rated which returned 7.35% as short-term interest rates moved higher, especially in the 4^th quarter of the year when the stock market continued to hit new highs. Non-Investment Grade Rated U.S. Corporate Bonds (High Yield Bonds) posted a strong return of 7.48% in 2017. The largest ratings sub-sector in High Yield, BB-Rated bonds (47% of market value), outperformed the lower credit B-Rated bonds (39%) posting a 2017 return of 7.16% vs 6.76%, as seen in the chart below. In 2017 the best large corporate bond sector to own was BBB’s. 

Source: Dial Capital Management, LLC | Past performance is not indicative of future results.

Short-term interest rates rose significantly in 2017 as a result of three federal funds rate increases. On January 16, 2018 the yield on the U.S. Treasury 2-year note went over 2% for the first time since August of 2008, rising from 1.26% just four months ago and has continued to move higher through the rest of the month. It now yields more than the dividend yield of the S&P 500 which hasn’t happened since 2007. The longer parts of the yield curve were much more stable in 2017, with the 5-year Treasury yield increasing less than half as much as the 2 year. The 10-year Treasury yield actually fell slightly for the year and the 30 year yield dropped over 30 basis points (0.3%), see the “Change in U.S. Treasury interest rates in 2017” chart below. This strength on the longer end of the curve was primarily due to the significantly lower international sovereign interest rates (e.g. the German 10-year Bund yield is currently 0.56% and had a negative yield in the summer of 2016), as well as the lack of clear signs of increasing inflation. The strength of the long end of the yield curve and weakness on the short end meant that longer bonds outperformed in every ratings category in 2017 (see the “Total Return by Maturity” chart below).

Source: Dial Capital Management, LLC | Past performance is not indicative of future results.

Source: Dial Capital Management, LLC | Past performance is not indicative of future results.

The corporate bond new issue market continues to set records. In 2017 $1.42 trillion of Investment Grade Corporate Bonds were placed in 2,299 issues, both post-Great Recession highs. The High Yield market placed $333 billion in 698 issues, which while not a record was a 35% increase in dollar value over 2016. Good companies have no trouble refinancing maturities in today’s market. Strong corporate profits and a robust new issue market work together to keep default rates near historic sub-3% default rates.

During 2017 economic conditions, both domestically and globally, continued to improve with rising leading indicators and falling unemployment, leading to very strong equity markets. Non-agriculture commodities (energy & metals) staged a strong recovery in 2017, especially in the 2^nd half of the year. This also helped fuel the equity markets. All this equity strength had the effect of reducing already low default rates, allowing credit spreads (the yield corporate bonds pay above U.S. Treasury rates to compensate investors for the risk of default) to continue their march to tighter levels. As recently as September 2016 the BofA/ Merrill Lynch U.S. Investment Grade Corporate Bond Index was yielding twice as much as same-maturity US Treasuries (2.84% vs 1.41%). By year-end 2016, the yield premium had fallen to 62% (3.37% vs 2.08%), and by October 2017 the premium had dropped below 50%, a level it had tested in the middle of 2014, early 2011 and again in early 2010. It’s important to note that while the sub-50% Yield Premium is a post-Great Recession low (last time is was this low was 2007), it is still noticeably higher than the 10 years before that (the Yield Premium averaged 27% between June 1997 – June 2007, see chart below), when the S&P 500 was valued at nearly half where it is today, suggesting that corporate bonds could absorb even higher interest rates without trading at higher yields / lower prices via a justified further reduction in credit spreads from today’s levels while staying within historical ranges. 

Source: Dial Capital Management, LLC | Past performance is not indicative of future results.

Outlook for 2018:

Looking forward to 2018, the same elements that were driving 2017 are still in motion. Strong economic trends domestically and globally, a surging stock market, a U.S. Fed who plans further increases in the overnight lending rate and longer term global interest rates that are still materially below U.S. rates. In addition, the recent U.S. tax reform should be adding further fuel to U.S. corporate profits via lower tax rates.

In just the first few weeks of 2018 we have seen a further shift in the U.S. Treasury yield curve (see chart below), as the longer end capitulated somewhat and moved higher (albeit the 30-year Treasury yield is still lower than it was five years ago). The flattening of the yield curve is a concern for some investors, primarily a fear of an inverted yield curve (where short-term interest rates are higher than long-term rates) which has historically resulted in economic recessions. While the curve has flattened significantly, the spread between the 10-year Treasury rates and 2-year, a standard measure of the “flatness” of the curve, is still above 50 basis points and has a way to go before becoming inverted.

Source: Dial Capital Management, LLC | Past performance is not indicative of future results.

Given the prospects for further moves higher in the federal funds rate and the post-Great Recession low in credit spreads, what is the “sweet spot” in 2018 for corporate bonds investors? While High Yield bonds are traditionally less vulnerable than Investment Grades bonds to rising interest rates and also a bigger beneficiary of lower default risk, those factors appear to be largely priced in. Yields are also less than 1% above all-time lows and a credit spread today of only 328 basis points. In the Investment Grade arena, we believe BBB’s have the potential to once again be the best performing sector in 2018. This is because historically BBB-Rates bonds are less vulnerable to rising interest rates and benefit more from greater corporate profits and equity valuations than higher rated bonds typically are.

With further rate increases expected from the Federal Reserve in 2018, the short end of the curve has clear risks. At the same time, the prospects for signs of increasing inflation in 2018 seem higher than they have been in the recent past given rising commodity prices, tight labor markets and the continuing weakness in the U.S. dollar. If inflation risks do impact the market it will hit hardest on the longer end of the yield curve. This leaves the intermediate term (four to seven years) as the least vulnerable part of the yield curve in 2018.

CRN: 2018-0202-6395 R

Opinions in this piece are those of Dial Capital Management and are not necessarily that of AAM.