At the end of February, corporate bond investors were likely pleased with year-to-date 2010 investment performance. Both Investment-Grade Corporate Bond and High-Yield Bond performance was positive, however, a closer look revealed that Investment-Grade Corporate Bonds barely edged out Treasuries while High-Yield Bonds actually underperformed Treasuries through the first two months of 2010 [See table ]. The first two weeks of March have witnessed strong out-performance of Investment-Grade Corporate Bonds and High-Yield Bonds relative to Treasuries. While only a short period of time, we view the performance in March positively as corporate bonds kept pace during a favorable period for Treasuries. More importantly corporate bonds showed resilience, and in the case of High-Yield Corporate Bonds outright gains, as Treasury yields turned higher.
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Both Investment-Grade and High-Yield Corporate Bonds continue to exhibit improving fundamentals, a primary driver of a strong start to March. Creditworthiness depends upon generating the earnings to support interest payments. With fourth quarter 2009 earnings season all but over, 72% of companies in the S&P500 Index surpassed earnings expectations. Excluding Financials, which posted large gains given a very depressed fourth quarter of 2008, earnings increased a healthy 11.8% in the fourth quarter of 2009 compared to the fourth quarter of 2008, according to Bloomberg. While good earnings reports reflected cost cutting and improved productivity, top line revenue growth also increased in another positive sign for the sector. Revenue increased 6% overall, 3% excluding financial firms, during the fourth quarter of 2009 versus the same quarter in 2008.
Last week, the Federal Reserve reported that non-financial domestic corporate debt grew at a 1.4% rate in 2009, the slowest rate since 2002 and the last time corporations curtailed debt growth. While corporate bond new issuance has made news headlines the last few weeks and frequently did in 2009, issuance of new bonds has been offset by the sharp decline in commercial paper and other short-term corporate debt issuance. The data does not include the financial sector, but we believe it reflects the broader trend of corporate issuers overall reducing leverage in 2009. The 1.4% overall issuance growth rate pales to the 22% growth rate of the Treasury sector. The manageable pace of growth should not lead to a supply-imbalance and might benefit corporate bonds as investors continue to search for yield in a low-yield world.
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High-Yield Bond issuers have also posted stronger earnings, but received an additional lift as defaults continued to decline. Moody’s reported that the trailing 12-month global speculative default rate declined to 11.6% in February after peaking at 13.0% in December. Since this is a trailing number, it is important to note it reflects the elevated pace of defaults that occurred during 2009. The current pace of defaults has slowed dramatically as 10 issuers defaulted over the first two months of 2010 compared to 45 over the first two months of 2009. Additionally, Moody’s reduced their year-end 2010 default rate forecast to 2.9% from 3.3%. The lower expected default rate suggests investors may be willing to pay higher prices for bonds, requiring less of a premium to own lower-rated bonds. This premium is reflected in a narrower yield advantage, or spread, to Treasuries. We expect yield spreads to contract further, as bond prices rise, in response to lower defaults. In addition to improving fundamentals, a reduction in sovereign credit worries has helped power corporate bond performance so far in March. The Greek government made progress on additional fiscal austerity measures and Treasury yields increased in response as safe haven buying was reversed.
Concern Over Sovereign Debt
However, concern over the sovereign debt of some European nations may resurface as fiscal challenges remain and progress is developing slowly. Concerns over sovereign credit quality may not offset the positive underlying fundamental trends among corporate bond issuers, but could lead to bouts of weakness relative to Treasuries similar to what investors experienced in January and February of this year. Market participants will likely continue to debate the impact that high government debt balances might have on domestic economic growth prospects. Furthermore, earnings reports revealed the benefits of cost reductions, efficiencies are waning, and further earnings improvement will become more reliant on revenue growth. We believe revenue growth will come but slowly. As a result, we see the pace
of improvement in Investment-grade Corporate Bonds and High-Yield Bonds slowing going forward.
A slower pace of improvement is just fine, however, corporate bonds may offer investors higher income that may buffer periods of under-performance relative to Treasuries. In both January and February, income helped both Investment-Grade Corporate Bonds and High-Yield Bonds keep close pace with Treasuries. With Treasury valuations high and yields still near historic lows, we continue to favor the higher income generation and improving fundamentals of corporate bond sectors.
- This was prepared by 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 fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- 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.
- This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specifi c tax issues with a qualified tax advisor.
- International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
- The Barclays U.S. Corporate High Yield Index covers the USD-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 index excludes Emerging Markets debt. The index was created in 1986, with index history backfi lled to January 1, 1983. The U.S. Corporate High Yield Index is part of the U.S. Universal and Global High Yield Indices.
- Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
- The Barclays Treasury Index consists of public debt obligations of the U.S. Treasury with a remaining maturity of one or more years. The index does not include Treasury bills, Treasury STRIPS, or Treasury Inflation-Protected Securities (TIPS).
- The Barclays Corporate Index is an unmanaged index of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The index includes both corporate and non-corporate sectors. The corporate sectors are Industrial, Utility, and Finance, which include both U.S. and non-U.S. corporations. The noncorporate sectors are Sovereign, Supranational, Foreign Agency, and Foreign Local Government. Bonds must have at least one year to final maturity, must be dollar-denominated and non-convertible, and must have at least $250 million par amount outstanding. Bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody’s, S&P, Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment-grade.