The $1.5 trillion Tax Cuts and Jobs Act of 2017 is expected to beef up business bottom lines, making corporate bonds attractive additions to a balanced portfolio, but as it happens, there are other reasons to be bullish — and cautious — about these investments.
Lower corporate tax rates immediately increase cash flow, which can be used to reduce debt, invest in new equipment or hire more employees, says Nichole Hammond, a senior portfolio manager with Angel Oak Capital Advisors in Seattle. This improves the company’s credit quality and the bonds it issues in order to grow.
[See: 7 ETFs for Income Investors to Play It Safe.]
And with the current long-running bull market due for more corrections, corporate bonds are likely to rise in value as stocks fall, says Scott Haley, the founder of Prelude Financial in Wadsworth, Ohio. A declining stock market would lead investors to seek safety in bonds, potentially pushing bond prices up.
That is the reverse of what is happening now. A thriving stock market and economy have prompted the Federal Reserve to raise interest rates, with more increases expected this year. The rate hikes haven’t done the overall bond market any favors (when rates rise, bond prices fall), but shifting more of your holdings to fixed income now is a smart defensive move.
“A prudent investor should lock in gains from equity holdings and invest more in fixed-income investments such as corporate bonds,” Haley says. “If we look back to the 2008 recession, we can see that investors who had larger portions of their portfolio invested in bonds actually performed well and experienced positive gains while the majority of investors were losing.
“This is a self-correcting mechanism that if timed right can yield handsome returns to an investor if they diversify their portfolio prior to a market correction or recession,” Haley says.
But the corporate bond market has dramatically increased in size and complexity over the past decade, according to a report by the Wells Fargo Investment Institute. While investment-grade corporate bonds are offering “compelling yields,” investors should stick to fundamentals and be selective. Here’s how.
Look for high-quality, short-term maturities. Because of the effect that rising interest rates have on corporate bonds, the Wells Fargo Investment Institute recommends broadly diversifying them with other securities and reducing overall exposure to high-yield bonds.
Corporations often leverage debt to grow, and rising interest rates could make that debt more expensive. About 10 percent of corporate debt has variable interest rates and would become more costly if rates rise, according to the Securities Industry and Financial Markets Association.
Watch the federal deficit. The Congressional Budget Office predicts the budget deficit will rise from $665 billion in 2017 to approximately $1 trillion in 2019 and $1.5 trillion in 2028. If gross domestic product doesn’t accelerate just as rapidly, there could be a significant increase in interest rates to attract funding, Hammond says. Higher rates increase the cost of credit to corporations and consumers alike, potentially slowing the economy.
[See: 7 Bond Funds to Buy as Rates Rise.]
Beware of “fallen angels.” A fallen angel is a bond that had an investment-grade credit rating, defined as BBB- or better, and has since been downgraded to high yield, defined as BB+ or lower, because of weakening financial conditions or too much debt on the issuer’s balance sheet, says Greg Haendel, a senior portfolio manager with Tortoise in Los Angeles.
Since the financial crisis, corporate America has been on “a borrowing binge,” pushing up the average investment-grade debt to a post-crisis high of nearly three times a company’s annual earnings before interest, taxes, depreciation and amortization (EBITDA). Although highly leveraged companies are riskier, the interest rates they pay to bondholders haven’t kept up and are at their lowest levels post-financial crisis, Haendel says.
The Tax Cuts and Jobs Act also reduced a company’s deductible interest expenses from 100 percent to 30 percent of EBITDA in five years. That will reduce the cash flow available to highly leveraged companies to service their debt, especially if interest rates rise substantially, Hammond says.
Pick your industry carefully. Highly leveraged debt is often “hiding” in noncyclical industries such as health care, food and beverage, telecommunications, media, cable and technology, says Haendel. These sectors tend to leverage their debt highly to acquire other companies.
Haendel cites as an example General Mills (ticker: GIS), which recently increased its leverage to roughly 4.5 times when it acquired Blue Buffalo Pet Products. While companies may anticipate long-term success from taking on so much debt, “any corporate misstep, unforeseen competition or macroeconomic downturn or shock could derail their lofty deleveraging plans, which in most cases have virtually zero margin for error,” Haendel says.
Always diversify. Corporate bonds are an essential part of diversified fixed-income allocations, says Dan Eye, a senior portfolio manager at Roof Advisory Group in Harrisburg, Pennsylvania. High-quality corporate bonds offer investors more attractive interest rates or yields than ultra safe U.S. government-issued bonds but also carry a higher risk of default.
There is a lot of talk that the spread between government bonds and corporate bonds is narrower than it should be and therefore corporate bonds are overpriced, says David W. Barnett, owner of Grand Arbor Advisors in Forth Worth, Texas. “I tend to look at this spread more positively,” he says. “To me, it means the marketplace is pricing in a much lower default risk than what we’ve seen historically.”
Nevertheless, to hedge that risk, spread your money around a large number of companies or sectors. Exchange-traded funds and mutual funds give investors a broader exposure to more companies.
Weigh the risks. Long-term bonds in a rising-rate environment may actually carry more risk than the stock, says David S. Thomas Jr., CEO of Equitas Capital Advisors in New Orleans.
A 10-year bond at 2 percent has a duration risk of eight, he says. That means for every 1 percent interest rates move up, the value of the bond goes down 8 percent. “Investors have not seen this environment for 30 years and are just starting to see it now,” Thomas says. “Most do not know what to do.”
Barnett is cautious about tying up money long term given that interest rate risk is more pronounced. “The sweet spot in the bond market right now is mid-range maturities seven to 15 years,” he says.
For long-term investors, corporate bonds may not be the best move anyway compared with stocks. At the beginning of the year, 10-year AT&T bonds had a 2.5 percent yield. A $100,000 investment in the bonds would yield $25,000 in interest over 10 years and give you your principal back.
[See: 7 Dividend Stocks Yielding 7 Percent and More.]
The same investment in AT&T ( T) stock pays a dividend of 5 percent, yielding you $50,000 in dividends over 10 years. Of course, you don’t know what the stock’s value will be in a decade, but the share price would have to drop 25 percent before you would break even with the bond, Thomas says.
More from U.S. News
7 Monthly Dividend Stocks for Steady Income
9 Cheap Dividend Stocks for Bargain Hunters
7 Classic Inflation Hedges and Their Thorns
Why You Should Be Bullish About Corporate Bonds originally appeared on usnews.com
