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.
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:
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- 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.
- 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.
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