As we approach the midpoint of 2021, the markets are off to a great start. The S&P 500 Index is up almost 13% year-to-date and corporate management teams have a great deal of optimism that growth will continue. On the fixed-income side, interest rates had been increasing on expectations of higher inflation and corporate spreads had been compressing as credit risk has been diminishing.
The sum of those two moving parts is that the all-in yield for investment-grade corporate bonds is approximately 2.1%. For perspective, the investment-grade corporate yield was near 2.8% at the start of 2020 (pre-pandemic). It then spiked to 4.5% at the height of pandemic fears and subsequently bottomed out near 1.75% by the end of 2020. So here we are at 2.1% for investment-grade corporate bonds, and the equity markets are near all-time highs — what is an investor to do?
If we dig a little bit deeper into the corporate bond market, we can potentially find some more yield without significantly more risk. The high-yield market is close to 4%, which doesn’t sound like that high of a yield, but this market is generally shorter in duration than its investment-grade counterpart. So for those who are worried about higher inflation and interest rates, this could be a nice place to put capital to work. With that said, high yield spreads as a whole may not be too compelling either and are also near their tights of the last decade. BB-rated corporate bonds may represent a safer way to reach for yield and better protect your investment from higher interest rates.
In this week’s chart, we can see the relationship in spread for BB (the highest-rated high yield) bonds versus investment grade-rated BBB corporates (lowest-rated investment grade). Since 2003, there have only been a handful of times when the spread of the BB bonds was more than twice the size of the BBB bond spread. Currently, we are north of that two-times ratio, which may present a decent opportunity to pick up extra spread and reduce duration. Moreover, if this relationship reverts back to the long-term average of closer to 1.8 times, there may be an opportunity for relative outperformance.
In this low-rate environment, every basis point matters that much more. Trying to find alpha can be difficult with corporate spreads compressed across ratings and duration. However, there may be an opportunity to move from BBB credits to BB without increasing credit risk too materially. There have been a decent number of fallen angels (credits that were rated investment grade and are now high yield) that could potentially be upgraded back to investment grade in this improving economy. Additionally, if the relationship of BB spreads to BBB compresses back to the long-term average, one could expect to achieve relative outperformance. Ultimately, each credit is different and building a diversified portfolio is key. For those looking to improve their portfolio returns, this could be a great opportunity to outperform peers and add some alpha.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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