It’s been a tale of two circumstances this year for corporate bonds.
For starters, U.S. investment-grade corporate bonds dropped 18.72% through Sept. 30, according to data from Bloomberg and J.P. Morgan. Much of this volatility has been brought on by the Federal Reserve’s six rate hikes to a target range of 3.75% to 4%. For perspective, that’s the highest fed funds range since 2008.
Corporate bond investors typically expect a steady experience in a down market, along with a competitive return, and the events of this year have tested that long-held narrative. After all, according to Bloomberg, core U.S. bonds have dipped into negative territory only five times since 1977.
Still, as Albert Einstein once quipped, “In the midst of every crisis, lies great opportunity.” In the backdrop of falling corporate bond prices, yields have improved dramatically this year. According to data from Bloomberg and J.P. Morgan, yields to worst improved to 5.7% by the end of September. To put that into perspective, yields among corporate bonds have not been this high in nearly 12 years, according to Bloomberg.
Brian Donnelly, CFA and fixed-income strategist for Fidelity Investments, says that “increased rates and higher income streams from core bonds could increase the probability of higher returns. Long-term capital market assumptions in core fixed-income returns have risen to mid-single digits from low-single digits since the beginning of the year. Valuations have increased across the board and made bonds viable again.”
For financial advisors who support clients’ long-term planning objectives, here are three viable reasons to take a second look at corporate bonds now:
— Competitive yields without high risk.
— Outlook for bonds has improved.
— Back to portfolio resistance for corporates.
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Competitive Yields Without High Risk
As of Nov. 1, Moody’s Seasoned Aaa Corporate Bond Yield was 5.09%. This same benchmark had a yield of 2.61% on Nov. 1, 2021. Corporate bonds with the Aaa credit rating, which is the highest rating available for this asset class, are seen as reflecting strong underlying financial health and a low probability of default.
For comparison, as of Nov. 1, the Moody’s Seasoned Baa Corporate Bond Yield was 6.29%. While the Baa rating is still considered to have a relatively low risk profile, it is one notch above junk-bond status. This same benchmark had a yield of 3.27% on Nov. 1, 2021.
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Outlook for Bonds Has Improved
Typically, when there has been an inversion between the 2-year and 10-year Treasury yield — like we have experienced this year — it signals an impending economic recession. That may very well be the case this time — only time will tell.
In recent history, however, the 2- and 10-year Treasury inversion has also been a green light for bonds during the following two years. After such inversions, the cumulative returns in the next 24 months for the Bloomberg U.S. Aggregate Bond Index, which includes corporate bonds, were 13.7% in 2006, 12.6% in 2007 and 6.4% in 2019, according to data from Vanguard and Bloomberg.
Better still, Vanguard’s 10-year outlook for U.S. aggregate bonds is a return range of 4.1% to 5.1% and median volatility of 6%. Compare those figures to Vanguard’s outlook for U.S. stocks, which includes a range of 4.7% to 6.7% and median volatility of 17.6%. Vanguard’s 10-year projection for the non-U.S. stocks is in the range of 7.5% to 9.5% and has a median volatility of 19.1%. The takeaway for clients who need balanced portfolios and 6% long-term returns to sustain their financial plans is that bonds can add value with substantially less risk.
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Back to Portfolio Resistance for Corporates
In September, the Federal Reserve projected that the “longer-run” real growth rate of corporate profits in the U.S. would recede by 2 percentage points to a range of 3% to 3.5%. If this happens, then up-in-quality corporate bonds, with strong balance sheets, would be in a better position to weather the storm than high-yield bonds.
T. Rowe Price, however, has a contrarian view about corporate bonds. The firm maintains that the next recession will likely be brought on by inflation — not credit risks. As many corporations strengthened their balance sheets during the pandemic, the company’s research indicates that inflation-driven recessions — like in 1982 and 1983 — have historically had a less invasive impact on corporate profits relative to credit-driven recessions, as was the case in the dot-com bust in 2000. For these reasons, T. Rowe Price believes that high-yield corporate bonds should hold up well during the next recession.
Corporate bonds currently offer clients access to yields that have not been available in more than a decade. If an economic slowdown does occur in the coming months, both investment-grade and high-yield bonds can potentially serve as a balancing force for clients’ portfolios. The long-term outlook for core U.S. bonds, including corporates, means that clients have options to help them get ahead on priorities like saving for retirement.
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The Case for Corporate Bonds in 2023 originally appeared on usnews.com
Update 11/08/22: This story was previously published at an earlier date and has been updated with new information.
