Central banks have taken on a renewed focus for corporate bond investors given China’s recent moves to tighten monetary policy. Over the past two weeks, concerns over policy tightening in China have led to US Treasuries outperforming more credit sensitive corporate bonds. This week, all eyes shift towards the Federal Reserve’s Federal Open Markets Committee (FOMC) meeting. While an interest rate change is not expected, investors will closely scrutinize the FOMC’s statement for any movement towards an exit strategy and removal of monetary stimulus. If the Fed takes a step towards removing stimulus, investors may view the economy as being at risk for a possible “double dip” recession and thus question the future creditworthiness of corporate bonds.

photo credit: George E.Martin

A look back at prior episodes of Fed monetary-policy tightening reveals that corporate bonds, both investment-grade and high-yield, continued to outperform Treasuries following the start of interest rate hikes in 1994 and 2004. Visually, the easiest way to see the out-performance of corporate bonds is to view the change in yield differentials, or spreads, to Treasuries. A narrower yield spread reflects stronger investor preference for corporate bonds, while a wider yield spread reflects weaker demand for corporate bonds and stronger demand for Treasuries.

In 1994, high-yield bond spreads contracted through the first Fed rate increase before leveling off and then rising before finishing slightly narrower a full year after the Fed’s first rate increase. The continued improvement is even more pronounced among investment-grade corporate bonds where yield spreads steadily contracted following the first rate hike. [Chart 1] Narrower yield spreads translated into out-performance with investment grade corporate bonds and high-yield bonds outperforming treasury bonds by 0.4% and 1.2%, respectively, as measured by Barclays Index data, for the subsequent 12 months after the first Fed rate increase. While the knee-jerk market reaction to a Fed rate increase is often negative, it usually reflects the Fed’s belief that the economy is strong enough to withstand higher interest rates. However, a strong economy is also reflected in corporate bond issuers improved profitability and greater cash flow to service debt payments, both positives for bondholders. Corporate and high-yield bond performance is even more impressive considering the Fed’s aggressive rate hike campaign, which took the target Fed Funds rate up a full 3.0% to 6.0%
from January 1994 to January 1995.

Corporate Bonds and High-Yield Bonds Spreads Contract

Similarly, investment-grade corporate bond and high-yield bond spreads contracted over the 12 months following the Fed’s first-rate increase in June 2004 [Chart 2]. Investment-grade corporate bonds and high-yield bonds outperformed Treasuries by 0.5% and 4.6%, respectively, over the same time period. Again, investor confidence in the economy and improving fundamentals for corporate bond issuers led to out-performance despite steady rate hikes by the Fed. In 2004, corporate bonds were aided by the Fed’s more gradual approach of steady 0.25% rate increases rather than the occasional 0.50% increase utilized in 1994. The target Fed Funds rate increased by 2.0% from June 2004 to June 2005 compared to the 3.0% rise over the January 1994 to January 1995 period. The story was different in 1999, as yield spreads widened and corporate bonds underperformed following the onset of Fed rate hikes. However, in 1999, we believe a unique set of circumstances conspired against corporate bonds:

• First, the Asian crisis during the fall of 1998 put corporate bond investors on edge. Fear of “contagion” to the rest of the world left little room for error. Still, corporate bond spreads narrowed up until the first rate increase in May 1999 as investors refocused on strong domestic economic growth. The economy grew at a 7.1% rate in the fourth quarter of 1998 as measured by GDP.
• Second, a budget surplus prompted discussions of a Treasury buyback program in the fall of 1999. In January 2000, the Treasury announced its buyback program helping Treasuries outperform in a very difficult bond environment.
• Lastly, Fed rate hikes in 1999 came late in the business cycle following a nine-year expansion. With the Fed Funds rate already elevated at 4.75%, rate increases were viewed negatively for the future financial health of corporate bond issuers.

As the economy likely emerged from the Great Recession during the third quarter of 2009 and with the Fed Funds target rate at a historic low, we believe today’s environment is different from that of 1999. A new economic expansion is underway globally and we expect the Fed will wait until late 2010 to raise interest rates. The Fed has also employed a greater range of policy tools this time, including the use of special funding facilities and bond-purchase programs. We believe the Fed will continue along the path of winding these programs down before increasing interest rates. In sum, the Fed is likely to take a “wait and see” approach to nurture the budding recovery and not risk tipping the economy back into recession.

We find the current period to be more similar to the 2004 period. Current yields are at similar levels and the target Fed funds rate was not much higher than today’s rate. Therefore, the corporate bond investors should not fear potential Fed rate increases. Fed rate hikes will likely lead to lower overall bond market performance but we continue to believe that corporate bonds, high-yield in particular, will help lead performance within the bond market. While Federal Reserve interest rate increases are to be taken seriously, investors need to weigh the reasons for the rate increase: most notably a stronger economy that has likely translated into better creditworthiness of corporate borrowers. At a time when government indebtedness of developed countries is reaching unprecedented levels, we continue to favor high-yield and investment-grade corporate bonds despite the possibility of eventual Fed interest rate increases.

IMPORTANT DISCLOSURES

• This was prepared LPL Financial. 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.
• Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed 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 diversified portfolio of sophisticated investors.
• International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
• Stock investing involves risk including loss of principal.
• 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.

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

photo credit: serhio

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

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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.