Investment-grade corporate bonds are posting losses, but investors keep sending cash into the market anyway. Those inflows could soon stop, or even reverse.
So far this year, the ICE BofA U.S. Corporate Index has posted a loss of 3.2%. The iShares iBoxx $ Investment Grade Corporate Bond ETF (ticker: LQD), which tracks the most liquid bonds in that market, has declined 6.6% in that time. Yet mutual funds and ETFs investing in investment-grade bonds have attracted inflows every week this year through March 10, totaling $52.7 billion, according to Refinitiv Lipper.
At least one team of market strategists thinks investors will—and should—get more bearish soon. Strategists at Pavilion Global Markets say that there is “virtually no value proposition under any given economic scenario” for higher-rated corporate bonds, and that investors should “be mindful of the potential for significant outflows in the days to come.”
The bond market’s losses have been driven by its duration, or its sensitivity to losses when benchmark Treasury yields rise. And yields have certainly been rising, with the 10-year note up 69 basis points, or hundredths of a percentage point, for the year through Monday.
Duration rises when coupons decline and maturities lengthen. And it has climbed to record highs in the past year, as companies extended the maturities of their pandemic borrowings while interest rates were low. The market’s duration climbed to a record high in November, and while it has declined since, it is still higher than it was any time before March 2020.
And if companies keep issuing long-term debt to get ahead of rising benchmark yields, duration may start to creep up again. Verizon Communications (VZ), for example, sold $25 billion of bonds last week to finance purchases of wireless spectrum, with nearly $12 billion of that maturing in 20 years or longer.
“While our take is that any inflation—and higher benchmark rates—will be transitory, the downside risk to LQD with duration at all-time highs is too significant to ignore,” the Pavilion Global strategists wrote in a March 15 note. “While growth is generally supportive of credit quality…high yield [bonds] offer better nominal yields…and less downside risk as and if rates rise.”
To be sure, corporate bonds aren’t the only investments that have experienced losses because of rising Treasury yields. The 10-year Treasury note had its third-worst start to a year since 1830, according to Deutsche Bank, and the iShares 20+ Year Treasury is down nearly 14% so far in 2021.
Even with those losses, yields across markets remain low; the 10-year yield is hovering around 1.6%.
That has left “carry,” or investors seeking out an extra yield premium over Treasuries, as the main selling point for the investment-grade bond market this year so far, as Goldman Sachs pointed out in a recent note. All of its outperformance over Treasuries this year can be explained by investors looking for carry, the bank found.
But investors don’t have much extra yield to harvest from investment-grade bonds anymore. The gap between yields on investment-grade bonds and Treasuries, which represents the extra compensation investors demand for the risk of default, has declined closer to lows from the past decade.
Investors are demanding about 1 percentage point of spread to own corporate bonds, according to ICE Indices, well below their 4-percentage-point peak during the pandemic. That spread is also relatively close to its post-financial-crisis low of 90 basis points.
Investors should look at the post-financial-crisis era as a comparison for the investment-grade bond market’s spreads, because of another market trend that Pavilion Global highlights as a risk: A decade-long deterioration of credit quality in the investment-grade bond market.
Nearly 51% of the market is rated in the three tiers closest to junk, known as the BBBs, up from 39% in 2005, according to ICE.
That raises the question of whether ratings firms (such as Moody’s and S&P Global) will continue to downgrade investment-grade companies, or if continued economic growth will make it easier for firms to increase their earnings and reduce debt.
Pavilion Global expects downgrades to continue in the investment-grade bond market, but that is an out-of-consensus call, especially after the S&P 500 posted a strong fourth quarter, surprising analysts with earnings that grew from the prior year.
For its part, Wall Street has already started to look past the pandemic-related downgrades. J.P. Morgan Chase, for example, expects more than $250 billion of “rising stars” in 2022, or bonds that are upgraded to investment grade from junk.
Even if no wave of downgrades surfaces, the market’s duration could lead to more losses if Treasury yields continue to rise as expected. So Pavilion Global strategists favor junk-rated bonds instead, as they offer a wider yield buffer over Treasuries.
Write to Alexandra Scaggs at alexandra.scaggs@barrons.com
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March 17, 2021 at 06:00PM
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Investment-Grade Corporate Bonds Offer ‘Virtually No Value’ Right Now. Here’s Why. - Barron's
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