When I entered the investment management industry in the mid-1980s, the 10-year US Treasury note yielded over 10%. Since then, there’s been a remarkable trend lower in yields.
This decline has often resulted in impressive annual performance for corporate bond investors, like last year’s 14.2% return. However, with stock prices collapsing from their mid-February peak and credit spreads increasing substantially, investors’ concerns around credit quality and rate sensitivity have grown even though investment-grade corporate bonds have performed well this year. The question we’ve been hearing most often from ladder clients is “Do the risks outweigh the potential returns in the investment-grade corporate bond market?”
In the interest of answering this question, let’s look at the benefits of managed corporate ladders and why they outweigh the risks—no matter the market cycle.
Historically low yields
So far in 2020, Treasury rates have declined again primarily due to the economic impact of the coronavirus, which triggered the Fed’s surprise rate cut of 50 basis points (bps). The yield on the 10-year Treasury note recently set an all-time low of 33 bps, dragging other domestic fixed income yields lower as well. This year, wider credit spreads have been more than offset by falling rates, resulting in historically low yields on the ICE Bank of America US Corporate Index* (ICE BofAML US Corporate Index), which now stand at 2.8%.
Prior to the recent financial markets sell-off, record inflows into investment-grade bond funds in January and February were indicative of the broad investor demand for the asset class. We believe the attractive characteristics inherent to the corporate bond market remain intact. Historically they’ve produced higher income than Treasury notes while providing principal stability and diversification benefits. For long-term corporate ladder investors, we believe the rewards continue to outweigh the risks.
Price stability and diversification
Last week’s collapse in oil prices along with growing virus fears sparked one of the worst days ever in the investment-grade corporate bond market. Not surprisingly, the energy sector was particularly weak. Despite investment-grade corporate bond prices falling materially on the day, the corporate bond market has actually performed well in 2020, producing a year-to-date total return of 1.3%. Importantly, investment-grade bonds have once again proved to be a good diversifier to equities.
Credit spreads protect against rate shocks
Credit spread is the additional yield over Treasury notes that investors receive for owning a corporate bond. Credit spread provides compensation for defaults and downgrades and typically acts as a shock absorber, dampening yield volatility when interest rates rise.
Investors have historically been well compensated for taking credit risk: The ICE BofAML US Corporate Index has outperformed Treasury notes with similar maturities by 50 bps per year since 1996. More important, credit spreads at 196 bps are almost double where they started the year and substantially wider than their pre-crisis 121 bps average. In our view, credit spreads are fairly valued and offer adequate compensation given the current state of credit fundamentals. Outside of the 2008 credit crisis, spreads have typically peaked in the 200–250 bps range during risk-off periods, so the current valuation already reflects material downside risk.
This is also the point in the cycle at which professional credit research can add significant value. As the economy slows and the credit cycle ages, the number of downgrades increases and more issuers fall from investment-grade to non-investment-grade. This downgrade cycle causes a significant drag on investment performance. Investors should look to strategies with the backing of credit researchers who review and approve each position with the goal of avoiding costly ratings downgrades. We believe this conservative approach of “winning by not losing” adds significant value over more traditional laddered accounts and indexes.
Ladders provide reinvestment opportunities
The ladder structure provides the opportunity to reinvest at higher levels in a period of rising rates. Because the ladder is rules-based, it systematically reinvests maturities at higher yields if interest rates rise or credit spreads widen. The reinvestment increases the yield of the portfolio over time, mitigating both rate and credit risk.
For instance, if investment-grade corporate yields moved back to 4%—a level last seen during the fall 2018 selloff—over the next three years, a one-to-10-year BBB corporate ladder would produce a positive return each year. The structure would additionally produce a 10-year cumulative return that would be 6.4% higher than if rates were unchanged.
The bottom line
As a young trader just out of college, I couldn’t have predicted that rates would be this low today. Now, 35 years later, I wouldn’t want to offer a view on the direction of interest rates or credit spreads given the uncertainties facing the markets. Long-term investors should favor ladder products designed to exploit the attractive characteristics inherent in the investment-grade corporate bond market. A combination of rules-based clarity and professionally managed fundamental credit research is designed to work well no matter when a client chooses to invest.
*The ICE BofAML US Corporate Index tracks the performance of US-dollar-denominated investment-grade-rated corporate debt publicly issued in the US domestic market. The index data referenced herein is the property of ICE Data Indices, LLC (“ICE”), its affiliates, or its third-party suppliers. ICE, its affiliates, and its third-party suppliers accept no liability in connection with its use.