Wednesday, December 12, 2012

Corporate bonds are moderately attractive

Over the past four years, corporate bonds have delivered total returns that rival those of equities. The S&P 500 has generated a total return of 77%; high-yield bonds (using HYG as proxy) have enjoyed a total return of 101%, for an annualized return of 19%; and investment grade bonds (using LQD as a proxy) have delivered a total return of 55%, or 11.6% annualized. The drivers of this spectacular performance were falling yields and lower-than-expected default rates. 

The chart above shows just how much yields on corporate bonds have declined since late 2008. In retrospect, the late 2008 surge in junk bond yields was a once-in-a-lifetime opportunity for investors willing to take the securities off of the hands of the many investors who were forced to sell at super-depressed levels. Towering yields at the time implied a massive wave of corporate defaults which never materialized, thanks to the recovery—however tepid it has been—and to the Federal Reserve's super-accommodative monetary policy stance.

So: is this the end of the greatest corporate bond rally in history? The chart shows that corporate bond yields are as low as they have ever been, so that is a sign that caution is warranted.

Digging deeper, swap spreads and credit default spreads, shown in the two charts above, suggest that there is still some room for improvement. The level of corporate bond yields is at an all-time low, but corporate bond spreads are still relatively wide. Furthermore, the significant decline in swap spreads suggests that corporate yields and spreads can decline further. If the economy keeps growing at a slow pace, short-term rates remain incredibly low, and monetary policy remains super-accommodative, investors will be all but compelled to continue buying corporate bonds for their still-attractive yields. For example, HYG has an indicated yield today of over 6%, while LQD's yield is almost 4%.

The case for corporate bonds would be bolstered fundamentally by continued improvement in the economy and relatively low default rates. A growing economy and easy money are a perfect recipe for improving corporate cash flows, and that is music to corporate bond investors' ears.

Still, with yields this low, investors should realize that there is a very small cushion against downside risk. If another recession hits, default rates would likely rise in that in turn would erode returns even if interest rates remained very low. If the economy were to strengthen unexpectedly, the Fed would be forced to tighten policy, and that could push corporate bond yields higher, which would also erode returns. It's probably time to start taking some—but not all—of your outsized corporate bond risk off the table, beginning with the investment grade sector.

Full disclosure: I am long HYG at the time of this writing.


Benjamin Cole said...

BTW, corporate debt issuance in 2012 dwarfed all previous years.

Also, Fed today announced it would do QE to tune of $85 billion a month, up from $40 billion.

These are bullish signs.

We can only hope the Bank of Japan, and the European Central Bank also get aggressive.

Inflation, like the Soviet Union, is yesterday's hobgoblin.

brodero said...

The folks need to be told about duration risk...LQD has a yield to maturity of 2.8% with an effective duration of 7.8....these are bad odds

McKibbinUSA said...

My advice is to avoid bonds until interest rates rise to at least 10-12% later in the century -- until then, bond investments don't pass the laugh test...

McKibbinUSA said...

PS: The Fed announcement to begin purchasing $45 billion in treasuries every month together with $40 billion in mortgage-backed securities until certain employment and/or inflation targets are hit will soon provide all of us the the empirical evidence needed to determine what's really happening in the US economy with regard to growth, employment, and inflation/deflation -- $95 billion monthly is a lot of cash being exchanged for treasuries and mortgage-backed securities -- the economic lessons learned are about to become clear...

Chris said...

I've been pounding the table for high-yield for a while now and I'm not stopping. Given that nothing changed politically last month, I expect more of the same in the economy and federal policies. Slow growth will continue, retirees will continue to look for yield, and corporations will continue to stockpile cash.

Benjamin Cole said...

CPI down 0.3 percent latest reading.

Dudes, inflation is dead.

Some people plot the dollar against oil prices and draw conclusions.

How about plotting the dollar against natural gas prices?