INSIGHTS

On July 02, 2018

Corporate Bonds Are Offering Better Value Today Than They Have in Several Years

So far 2018, as expected, has been a tough year in fixed income investments. The U.S. Federal Reserve has made it clear they intend to keep tapping the brakes on overnight interest rates and the ECB (European Central Bank) has announced they plan to end their quantitative easing purchases by year end. Both central bank actions point to higher yields and lower bond prices. In the first six weeks of 2018 the markets stuck to the increasing interest rate script: The 10-year U.S. Treasury yield started the year at 2.46% and by late February has jumped to 2.95%. Yet after spiking above 3% in April and above 3.1% in May we ended the second quarter with the 10-year at 2.85%. In response to higher Treasury rates, U.S. corporate bonds produced negative returns in both the first and 2^nd quarters of 2018 which more than offset the gains from the second half of 2017. What is the silver lining to this story for bond investors?

The Bank of America/Merrill Lynch (now called the ICE Indices) U.S. Investment Grade Corporate Bond Index is now above a 4% yield, the BBB Index above 4.4%. Outside of the panic of January 2016, yields haven’t been this high since 2011. Also, important to note, is that even while U.S. Treasury rates closed at the end of June essentially where they were in February, the corporate yield spread above Treasury rates has been increasing, up 40 basis points from the early February low. This is at a time when the S&P 500 Index remains within 5% of its all-time high. Despite concerns over further increases in interest rates, we find that new issuance of U.S. Investment Grade corporate bonds remains on track to set another all-time volume record in 2018, which will be the 7th year in a row of doing so.

In conclusion, while the concerns of bond investors going into 2018 seemed to have been realized in the first half of the year, Treasury rate increases have moderated, with rates for 10s & 30s falling in June, while credit quality reflected in equity valuations remains high and demand for new issues is as strong as ever. In our opinion, corporate bonds appear to offer better risk-adjusted yields as a result of the price contraction in the first half of 2018 than they have in several years and remain a solid diversification alternative to investors who are overweight an arguably expensive stock market.

Source: Bloomberg/Bank of America-Merrill Lynch (ICE)

CRN: 2018-0702-6742 R

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