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Will This Year’s Divergence Between High Yield and Investment-Grade Corporate Bonds Continue?

Junk debt returns outpaced investment grade. Could that change in the second half of 2018?

Returns on riskier corporate debt have been outperforming safer, investment-grade corporate bonds during the first half of this year. Is the tide poised to turn?

The shrinking availability of new junk bonds this year, higher oil prices – boosting the financial results of oil & gas companies that make up a good portion of the junk bond universe – and even trade tensions led to a good first-half performance for high yield bonds. That was not the case for investment grade corporate debt.

Total returns – including interest payments and price appreciation – for investment grade corporate debt fell 3.3% year-to-date through June as represented by the Bloomberg Barclays U.S. Corporate Bond Index. That was the index’s worst semiannual return since 2013, according to Charles Schwab1. In contrast, the Bloomberg Barclays U.S. High Yield Bond Index was up by 0.2% year-to-date.

The investment-grade universe’s dwindling results were partly down to rising Treasury yields and more Treasury issuance earlier this year as well as big bond sales in May and June as companies raised cash to pay for acquisitions.

“Investment grade (IG) bonds typically outperform their high-yield counterparts when uncertainty rises, given their higher quality and lower default risks,” Richard Turnill, Blackrock Global’s chief investment strategist, wrote in this July market insights2 piece, noting that “this hasn’t been the case lately thanks largely to issuance trends.”

The rise in economic uncertainty surrounding escalating talk of a full-blown trade war between the U.S. and its trading partners in the second quarter also did little to lift sentiment for investment-grade corporate debt. “IG issuers’ greater global exposure versus high yield issuers may also be playing a role in these performance trends as trade tensions rise. The trends have been exacerbated by a changing interest rate environment: IG issuers are wanting more debt funding in a more demanding environment,” Turnill wrote.

Shifts in Fixed Income Investing Climate

Indeed, the landscape for fixed income investing has changed in recent months, dampening demand for investment-grade debt from corporate investors as well as money managers.

On the one hand, large technology companies had generally been major purchasers of short-term investment-grade securities as part of their cash management operations. But they have generally opted to keep those funds in cash in preparation for the lower tax rates on offer for money repatriated as part of the tax reform package passed last December.

On the other hand, rising short-term rates on safe Treasury bills and notes have presented competition for investment-grade bonds of similar maturities. “There is less need to stretch for yield when dollar-based investors can get above-inflation returns in short-term ‘risk-free’ debt,” Turnill wrote earlier this month.

Today’s investment grade universe also presents more risk than in the past. Bonds rated single-A and triple-B comprised a quarter of the Bloomberg Barclays U.S. Corporate Bond Index as of the end of September 2017 compared to just 16% a decade ago, according to Charles Schwab3.

In addition, the average duration of the index is just below its all-time high. Duration is a measure of a fixed income investment’s sensitivity to interest rates. In general, the higher a bond or bond fund’s duration, the more it will be impacted by swings in interest rates.

“The high average duration is a key reason the investment-grade index has been such a poor performer this year ─ its average price is more sensitive to the rise in yields we’ve witnessed this year,” said Collin Martin, fixed income strategist for Charles Schwab Center for Financial Research.

As far as performance, Martin expects more of the same for the rest of the year, with a continual rise in Treasury yields and gradual interest rate tightening from the Federal Reserve potentially “pulling up” yields on corporate fixed income investments as well. “We don’t expect returns for investment-grade corporate bonds to be as poor in the second half as they were in the first, but the markets are still challenging,” he wrote.

“Despite the headlines, investment-grade corporate bonds are beginning to look a bit more attractive for income investors. But given our outlook for modestly higher bond yields, price appreciation is probably limited and coupon payments will likely be a key driver of second-half returns.”

For his part, Turnill notes that higher short-term interest rates “may be here to stay” but Blackrock expects quality debt of investment grade companies “to reassert their typical resilient nature” following the surge in recent new issuance. For underperformance to persist, new issuance expectations would need to persist ─ a scenario Blackrock views as unlikely. And against that backdrop, valuations of investment grade corporate debt have become more attractive relative to high yield.

“Yields for short-maturity investment grade corporates are now well above the level of U.S. inflation,” Turnill wrote. “We see these assets again playing their traditional portfolio role—principal preservation, especially in an increasingly uncertain macro environment.”

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Sources:

 

1- https://www.schwab.com/resource-center/insights/content/2018-mid-year-credit-outlook-rising-yields-growing-debt-levels?cmp=em-QYB

2- https://www.blackrockblog.com/2018/07/08/quality-credit/

3-  https://schwab/resource-center/insights/content/hidden-risks-bond-benchmarks

4-https://leveragedloan.com/us-leveraged-loan-issuance-totals-274b-2018s-first-half/

5- https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1134760

6- https://www.fitchratings.com/site/pr/10038909 https://www.schwab.com/resource-center/insights/content-hidden-risks-bonds-benchmarks

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