Credit Mid-Year Outlook: Turbulence Ahead

Key Points

  • Exercise caution in the risky parts of the corporate bond market. Upside is limited, while there’s a growing risk of sharp price declines.

  • High-yield corporate bonds and bank loans likely face the greatest risk of price declines.

  • Preferred securities can still make sense for long-term, income-oriented investors, but volatility may be elevated.

Proceed with caution in the corporate bond market. Despite a strong start to 2019, it’s unlikely the strong pace of returns will continue in the second half of the year, especially in the lower-rated, riskier parts of the corporate bond market.

Credit market returns have been strong this year

Source: Bloomberg. Indexes represented are the Bloomberg Barclays U.S. Treasury Bond Index, Bloomberg Barclays U.S. Corporate Bond Index, Bloomberg Barclays U.S. Corporate High-Yield Bond Index, Bloomberg Barclays U.S. Floating-Rate Notes Index, ICE BofAML Fixed Rate Preferred Securities Index, and the S&P/LSTA Leveraged Loan 100 Total Return Index. Total returns from 12/31/2018 through 6/17/2019. Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

While we’ve had a relatively neutral outlook on most corporate bond investments for the past few years, the risks now appear to outweigh the potential rewards, and investors should consider reducing exposure if their holdings are not in line with their risk tolerance or investing time horizon.

With yields low and prices high, those strong year-to-date returns are unlikely to persist—investors should manage expectations accordingly. Returns through the end of the year are likely to be driven by coupon payments, not further price appreciation. In fact, we see a greater risk of prices falling, especially among riskier, lower-rated investments like high-yield bonds and bank loans.

Our cautious stance does not imply all corporate bonds need to be avoided, however. Below we discuss our outlook on investment-grade corporate bonds, high-yield corporate bonds, preferred securities, and bank loans.

Risks are rising

We’ve been highlighting the risks to the corporate bond market for some time now. However, there were plenty of factors that were likely to keep prices supported and prevent them from falling sharply, like strong corporate profitability in 2018 due to the cut to the corporate tax rate, easy financial conditions, plenty of liquid assets on corporate balance sheets, and high investor demand. Those factors are beginning to fade and other risks are beginning to brew.

Three factors that make us cautious on certain areas of the corporate bond market today are:

1. Inverted yield curve. Although the timing varies, an inverted yield curve (as measured by the three-month Treasury bill/10-year Treasury note yield spread) has generally meant a recession is on the horizon. As of June 17th, 2019, this yield curve has been in negative territory for more than three weeks.

Historically, a flat or inverted yield curve generally has led to low relative returns for the high-yield corporate bond market. With the yield curve now suffering a sustained inversion, we think there’s a growing risk of high-yield underperformance over the next six to 12 months, or even beyond.

A flat or inverted yield curve has generally led to low relative returns

Source: Bloomberg. Relative returns compare the 12-month total returns of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index and the Bloomberg Barclays U.S. Treasury 3-7 Year Bond Index depending on the starting slope of the 3-month/10-year Treasury yield curve,using monthly data from January 1994 through May 2019. Each starting point or ranges for the yield curve are based on quartiles, beginning in January 1994. Past performance is no guarantee of future results.

2. Global growth concerns. Slower economic growth, both domestically and abroad, poses a risk to the high-yield bond market, as it can lead to lower corporate profits. Recently, the JPMorgan Global Manufacturing PMI (purchasing managers index) dipped below 50—a reading that indicates contraction. Historically, dips in the global PMI have been followed by relatively large surges in credit spreads, but this time they’ve held up relatively well. We see a risk of wider credit spreads if global growth concerns persist.

Global growth concerns may pull spreads wider

Note: Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan.

Source: FactSet, Bloomberg. JP Morgan Global PMI Manufacturing Sector, Output Index, SA – World, Bloomberg Barclays U.S. Corporate High-Yield Bond Index (LF98OAS Index). Monthly data as of 5/31/2019 for the Global PMI and as of 6/14/2019 for high-yield spreads. Past performance is no guarantee of future results.

3. Corporate profitability. What was a supporting factor in 2018 now poses a risk to the market. Corporate profit growth was strong last year—for the full year, the year-over-year growth in before-tax profits of nonfinancial corporations rose 7.4%. It was even stronger in the third quarter, rising 10.4%, its largest year-over-year change since the second quarter of 2012.

Corporate profit growth was generally expected to slow this year as the effects of 2017’s Tax Cuts and Jobs Act faded, but there’s a risk of even slower growth if the trade concerns persist. If tariffs remain in effect for a prolonged period of time, consumer demand may slow due to higher prices, or corporate profit margins may take a hit if companies do not pass on the cost of tariffs to consumers. In the first quarter of this year, profit growth slowed to just 3.1%. If growth continues to slow, or potentially turns negative, corporate borrowers may struggle to make timely interest and principal payments.

Corporate profit growth may continue to slow

Source: Bloomberg, using quarterly data as of 1Q2019. FOF Corporate Business Corporate Profits Before Tax With Iva and CCadj NIPA (INCOCBCP Index).

What to do now?

It’s not all bad news in the credit markets, and investors don’t need to abandon their holdings. Different types of corporate bond investments have different risk and reward profiles, and it’s important to make sure that any investment is appropriate given your risk tolerance. In light of the risks today, don’t chase the higher yields offered in the riskier parts of the market—there’s a rising risk that price declines may offset the higher yields they offer.

1. Investment-grade corporate bonds. Consider moving up in credit quality, focusing on bonds rated “A” or above.

The risk profile of the investment-grade corporate bond market has changed dramatically over the years. Bonds with “BBB” ratings—the lowest rung of investment grade—now make up more than half of the investment-grade market. In 2008, they made up about a third of the market, up from just a quarter of the market in the late 1990s. In other words, with BBB-rated bonds making up more than half of investment-grade bond indexes today, investors are likely taking on more credit risk (the risk of default) if their bond funds are meant to track an index, compared to years past.

Given growth and corporate profit concerns, some, or many, of these BBB-rated bonds may be downgraded to sub-investment grade, which would likely lead to large price declines. Bond fund investors may want to consider funds that focus on higher-rated issues, while those who invest in individual corporate bonds should try to focus on issues with ratings of “A” or above.

2. High-yield corporate bonds. Consider reducing exposure. It often makes sense to take additional risks if you’re being compensated well for them, but that’s generally not the case with high-yield corporate bonds today. The average option-adjusted spread of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index is roughly 4%. While a yield advantage of 4 percentage points above comparable Treasuries might seem attractive, it’s below both the long-term and post-crisis averages, and not far off its post-crisis low. Given the risks, there’s a lot more room for spreads to rise (leading to lower prices) than there is for them to fall (leading to higher prices).

Credit spreads are relatively low 

Source: Bloomberg, using weekly data as of 6/14/2019.

3. Preferred securities. These arestill appear relatively attractive for investors looking for higher income, as long as they have long investing horizons and can tolerate elevated volatility.

Preferred securities have two key risks: interest rate risk, or the risk that their prices will decline if yields rise, and credit risk, or the risk of default or missed coupon payment. But those risks might not be as high as expected, even given the concerns already highlighted.

While preferred securities have long maturity dates, or even no maturity dates at all, they have elevated interest-rate risk. Given our outlook that yields are likely to stay “lower for longer,” risk of a drop in prices due to a rise in Treasury yields appears to be relatively low.

Preferred securities do have elevated credit risk. Because they generally rank below an issuer’s traditional bonds (meaning bondholders usually get paid before preferred-security holders), the risk of a missed income payment is a bit higher than it is for traditional bonds. However, most preferreds are issued by banks and other financial institutions. That’s a risk in and of itself—it’s difficult to get much sector diversification—but banks appear to be in pretty good shape these days. Over the past decade, most large banks have done a good job of strengthening their balance sheets and improving their capital levels. If corporate profit growth does slow or if recession is on the horizon, we still think banks will have a relatively high ability to stay up to date on their preferred securities payments.

Preferred securities should always be considered long-term investments, and they are prone to bouts of volatility or sharp price declines. Always make sure that any preferred securities investment is appropriate given your risk tolerance.

4. Bank loans. Lower your return expectations. Bank loans (also called senior loans or leveraged loans) have very little upside today, but lots of downside. Like our cautious outlook on high-yield bonds, bank loan prices are at risk of price declines through year end and beyond. Historically, the average price of the S&P/LSTA Leveraged Loan 100 index has rarely risen above $100, and over the past decade its high is just above $99. With a current price of $97.8, there’s very little room for prices to rise, but as the chart below illustrates, plenty of downside if market conditions deteriorate.

Meanwhile, bank loans have floating coupon rates. With the next move by the Federal Reserve likely to be a cut, income payments may be resetting lower in the future. With the potential for lower prices and lower income, bank loans don’t appear too attractive today.

Bank loan prices have very little upside

Source: Bloomberg, using weekly data as of 6/16/2019. Past performance is no guarantee of future results.

 

Next Steps

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Preferred securities are often callable, meaning the issuing company may redeem the security at a certain price after a certain date. Such call features may affect yield. Preferred securities generally have lower credit ratings and a lower claim to assets than the issuer's individual bonds. Like bonds, prices of preferred securities tend to move inversely with interest rates, so they are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and preferred securities, when sold before maturity, may be worth more or less than original cost. Preferred securities are subject to various other risks including changes in interest rates and credit quality, default risks, market valuations, liquidity, prepayments, early redemption, deferral risk, corporate events, tax ramifications, and other factors.

The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

The Bloomberg Barclays U.S. Treasury Bond Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.

The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services.

The Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

The Bloomberg Barclays U.S. Floating-Rate Notes Index measures the performance of investment-grade floating-rate notes across corporate and government-related sectors.

The BofAML Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market.

The S&P/LSTA U.S. Leveraged Loan 100 Index is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market. The index consists of 100 loan facilities drawn from a larger benchmark - the S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan Index (LLI).

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