Welcome! If this is your first time visiting, check out the story behind this blog. So you won't miss out on future updates, you may want to subscribe to my RSS feed. If you prefer a weekly email, try this option. Thanks for visiting and please come again!
After a strong start to August, Corporate Bonds, both Investment-Grade and High Yield, have underperformed Treasuries over the past two weeks. For the two weeks ending August 21, investment grade corporate bonds and high yield bonds underperformed Treasuries by 0.43% and 2.14%, respectively, according to Barclays data, after stripping out the impact of interest rate movements. Recent underperformance did little to dent the massive performance lead corporate bonds possess on a year-to-date basis.
Yield spreads to Treasuries widened but remain near early August levels. For high quality investment grade corporate bonds, the average yield spread to comparable Treasuries widened a relatively modest 0.1% to 2.5%. Although it resembles only a blip up on the chart, it still represents the only pullback of its kind in what has been a nearly uninterrupted run of narrower yield spreads since March.
Spread on High Yield Bonds
High Yield Bond spreads to Treasuries widened more, so far similar to what investors witnessed in June when wider yield premiums to Treasuries reflected concern over rising Treasury yields (the 10-year Treasury yield touched 4%) and concerns over the coming earnings season. Given the 2.2% gain in the S&P 500 Index last week, the pause in corporate bond markets is at odds with the equity market, causing investors to question whether the corporate bond rally is over. But recall that while corporate markets have recovered to pre-Lehman collapse levels, equities have not.
We remain positive on investment grade corporate bonds and high yield bonds, thanks in part to the second quarter earnings season. For the S&P 500, second quarter earnings were down 28% year-over-year, versus an expectation of down 36%. Although weak on an absolute basis, the improving trend is a positive for forward looking corporate bond markets. The majority of the earnings surprise came from cost cutting, but this is a positive for corporate bond holders. Once corporations embark on a path of repairing balance sheets, the benefits can accrue to bondholders for years. Note how credit quality improvements, reflected in narrower yield spreads, persist for long periods of time.
Corporate bond fundamentals may get an additional lift from better economic prospects for the second half. Consensus GDP forecasts for the third quarter have revised up to the 2.0–3.0% range, up from zero, and estimates for the forth quarter have been revised 0.5% to 1.0% higher as well. While we would label fundamentals as still weak overall, earnings season and prospects for economic growth are encouraging signs for fundamentals improving going forward.
Valuations still attractive
Perhaps most importantly, Corporate Bond valuations still look attractive and the investment thesis of investors being paid to wait is still very much valid. At a 2.5% yield advantage to Treasuries, investment corporate bond yield spreads are still 1.0% above the historical average. The 2.5% yield advantage is more impressive considering a 10-year Treasury yield under 4%. The yield advantage creates a high hurdle for government bonds to outperform
High Yield Corporate Bonds
In the high yield market, the current yield spread of 9.1% remains well above the 5.5% average. Defaults continue to rise in the high yield market, with Moody’s forecasting defaults to peak at 12% in the fourth quarter, while S&P has forecast a peak default rate of 14% for the first quarter of 2010. While alarming on the surface, the estimates have come down over the past couple of months, and investors are looking past the peak toward a decline in default rates in 2010. High default rates will likely keep yield spreads above historic norms well into 2010 and perhaps beyond, but that still leaves an impressive yield advantage.
Risks
New issuance could create a supply burden for corporate markets. With absolute yields on Investment-Grade Corporate Bonds now down to an average of 5.3%, the low end of the historical range, corporate treasurers may be motivated to take advantage of low yields to issue debt. Greater supply may be a challenge given narrower yield spreads. However, still-high cash balances at many corporations and weak capital spending argue against a pick up in new issuance. This is less of a factor in the high yield market where an average yield 11.5% is in the middle of the long-term range. For High Yield Bonds, defaults and the degree they surprise both to the up or downside of expectations will play a greater role.
Conclusion
The easy money in Corporate Bond markets has already been made, but we believe corporate bonds can still provide additional out performance. In sum, we believe there is still room for improvement as yield advantages to Treasuries remain high relative to historic norms. History has shown that over long periods of time, credit quality improvements benefit bondholders for years. Improvement is likely to come more gradually going forward, however, and bouts of weakness, such as what investors witnessed over the past two weeks, should not surprise investors. We would use such weakness to add to existing positions, as we continue to find corporate bonds attractive.
Carnivals of the Week
- Money Hacks Carnival #79 – Hack The Planet Edition @ Modern Tightwad.
- Carnival Of Everything About Personal Finance – 9th Edition @ Nil2Million.com.
- Carnival of Financial Planning – Edition #104 @ Four Pillars.
- Economy and Your Finances Carnival August 30 2009 @ One Mint.
- Carnival of Personal Finance @ Your Money Relationship
IMPORTANT DISCLOSURES
- The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- Neither LPL Financial nor any of its affi liates make a market in the investment being discussed nor does LPL Financial or its affiliates or its officers have a financial interest in any securities of the issuer whose investment is being recommended neither LPL Financial nor its affiliates have managed or co-managed a public offering of any securities of the issuer in the past 12 months.
- Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fi xed rate of return and fi xed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
- High Yield/Junk Bonds are not investment grade securities, involve substantial risks and generally should be part of the diversifi ed portfolio of sophisticated investors.
- GNMA’s are guaranteed by the U.S. government as to the timely principal and interest, however this guarantee does not apply to the yield, nor does it protect against loss of principal if the bonds are sold prior to the payment of all underlying mortgages.
- Muni Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and state and local taxes may apply.
- Investing in mutual funds involve risk, including possible loss of principal. Investments in specialized industry sectors have additional risks, which are outlines in the prospectus.
- Stock investing involves risk including loss of principal.
{ 3 trackbacks }
{ 0 comments… add one now }