Rabu, 12 Desember 2012

Corporate bonds are moderately attractive

Over the past four years, corporate bonds have delivered total returns that rival those of equities. The S&P 500 has generated a total return of 77%; high-yield bonds (using HYG as proxy) have enjoyed a total return of 101%, for an annualized return of 19%; and investment grade bonds (using LQD as a proxy) have delivered a total return of 55%, or 11.6% annualized. The drivers of this spectacular performance were falling yields and lower-than-expected default rates. 

The chart above shows just how much yields on corporate bonds have declined since late 2008. In retrospect, the late 2008 surge in junk bond yields was a once-in-a-lifetime opportunity for investors willing to take the securities off of the hands of the many investors who were forced to sell at super-depressed levels. Towering yields at the time implied a massive wave of corporate defaults which never materialized, thanks to the recovery—however tepid it has been—and to the Federal Reserve's super-accommodative monetary policy stance.

So: is this the end of the greatest corporate bond rally in history? The chart shows that corporate bond yields are as low as they have ever been, so that is a sign that caution is warranted.

Digging deeper, swap spreads and credit default spreads, shown in the two charts above, suggest that there is still some room for improvement. The level of corporate bond yields is at an all-time low, but corporate bond spreads are still relatively wide. Furthermore, the significant decline in swap spreads suggests that corporate yields and spreads can decline further. If the economy keeps growing at a slow pace, short-term rates remain incredibly low, and monetary policy remains super-accommodative, investors will be all but compelled to continue buying corporate bonds for their still-attractive yields. For example, HYG has an indicated yield today of over 6%, while LQD's yield is almost 4%.

The case for corporate bonds would be bolstered fundamentally by continued improvement in the economy and relatively low default rates. A growing economy and easy money are a perfect recipe for improving corporate cash flows, and that is music to corporate bond investors' ears.

Still, with yields this low, investors should realize that there is a very small cushion against downside risk. If another recession hits, default rates would likely rise in that in turn would erode returns even if interest rates remained very low. If the economy were to strengthen unexpectedly, the Fed would be forced to tighten policy, and that could push corporate bond yields higher, which would also erode returns. It's probably time to start taking some—but not all—of your outsized corporate bond risk off the table, beginning with the investment grade sector.

Full disclosure: I am long HYG at the time of this writing.

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