INSIGHTS

On October 21, 2020

What a Year It Has Been for Corporate Bonds

2020 has been a year unlike anything before for investors. Very early in the year we had record high stock prices, record low unemployment and were comfortably looking ahead to the 2020 Olympics Games and the U.S. presidential election. Then the world was turned upside down with the worst global pandemic in 100 years. When market prices fell as the reality of shutdowns became clear, they had never fallen faster. All asset classes in bonds fell together, from AA-rated to B-rated, corporate, municipal or asset-backed, everything was for sale all at once. It was a full-on panic, and as is almost always the case, the panic sales turned out to be a real buying opportunity.

The BBB 5-7-year U.S. corporate index – the corporate bond index we follow closely – had returned 3.8% by March 5 before COVID-19 lockdowns started the panic. By March 23 the index was -11.8% year to date (YTD), down 15% in 18 days – the worst correction ever. On that same day the Federal Reserve announced a massive quantitative easing package and took overnight lending rates to almost zero, they also announced that they would be buying investment grade corporate bonds in order to limit the deterioration of corporate financing conditions in the midst of the COVID-19 pandemic. They were willing to spend up to $750 billion. This was unprecedented support for corporate credit. The recovery in bond prices began immediately. By the end of the month the index had risen 5.7%, to -6.7% YTD. The Fed finally started buy corporate bond exchange-traded funds (ETFs) on May 12 and individual bonds on June 16. By May 21 the index was even for the year and on June 18 it was +3.8%, all the way back to the March 5 high. The most tumultuous three months in the history of corporate bonds.

As the year progressed, returns hit a high in conjunction with the stock market high on September 3, posting a YTD return of 6.9%. After correcting nearly 1% mid-month the index had recovered to +6.9% by the middle of October. That is already a better return than in five of the last eight full calendar years; something no one would have predicted at the beginning of the pandemic. The Federal Reserve’s quick action, along with the full recovery in the stock market indices, has helped protect bond investors as well as given companies the ability to issue new bonds to shore up their balance sheets for any earnings shortfalls that the pandemic may have caused. After a slow start 2020 is already the biggest year ever for sales of new U.S. corporate bonds.

It’s not all good news, of course. Corporate default rates, which were already on an uptrend from historic lows coming into 2020, have been rising significantly in 2020 due to the pandemic shutdowns. Default rate are now the highest level in a decade and are expected to continue to rise into the spring of 2021 before falling back to current levels a year from now. Note that these are Speculative Grade default rates, not Investment Grade credits. In our opinion, it is likely, however, that Investment Grade credits may experience an above-average ratio of credit rating downgrades to upgrades in a rising default environment, as they have historically.

Looking forward it is expected that Investment Grade U.S. companies will continue to be beneficiaries both directly and indirectly of the response and impact of the pandemic. The response of the direct Fed support of buying hundreds of billions of dollars of bonds in the secondary market, as well as offering to fund entirely new loans directly with the Fed, gave eligible companies unprecedented liquidity to keep their balance sheets strong. In addition, Congress pledged trillions of dollars of support, some of which also helped companies in specific industries. Indirectly, Investment Grade companies have and will continue to potentially benefit from being well-funded survivors who will pick up customers from the failed competitors who didn’t have the liquidity and equity to survive the abrupt slowdown in business from the pandemic shutdowns. When the economy recovers in 2021/2022, many of the Investment Grade companies could find themselves in better market positions with fewer competitors and superior growth prospects than they would have, had the pandemic not occurred. The strong could get even stronger, although there will inevitably be some missteps made by a few companies. As always, we believe security selection remains a critical aspect of corporate bond investing.

While 2020 has been a wild ride for all investors, Investment Grade corporate bonds have done better than the stock indices and are having an above-average year of returns. While the pandemic has damaged revenues and profits in the short term for many companies, Investment Grade companies have been able to raise a record amount of new bond issues at some of the lowest interest rates ever. The Federal Reserve has not only acted to lower interest rates in general, for the first time they are directly buying Investment Grade corporate bonds, a move that has reduced the risk profile for the asset class. Going forward, post-COVID-19 recovery prospects are above average due to less competition and plenty of liquidity to pursue new opportunities. The asset class has outperformed, and we believe continues to have good prospects for cash flow growth. Finally, the Fed has pledged to keep interest rates low through 2023, which reduces interest rate risk, something particularly helpful in our current low-rate environment.

CRN: 2020-1006-8613 R

The opinions and views of this commentary are that of Dial Capital Management and are not necessarily that of Advisors Asset Management.