For years, corporate bonds have provided investors a relatively low-risk way to increase their returns in a depressed interest rate environment. After a long and pronounced period of tranquility, the first quarter of the new year ushered in a period of unexpected market volatility, severing the long-term and advantageous bond/stock relationship.
The BofA Merrill Lynch U.S. Corporate AAA Index tells the story.
Over the past 10 years, investors have been able to have their cake and eat it too: relatively high yields with an overall favorable total return with low risk. This was due to the fact that bonds and stocks in general over the past 10 years tended to move in tandem. A historical quirk led to an inverse bond/equity relationship that persisted for at least a decade that inured to the benefit of investors.
A new investment climate has taken root: Rates are now rising, pushing yields on government bonds higher.
In addition, since the first of the year, the spread between high-grade corporate bonds and Treasuries has widened, resulting in price drops that gave bonds a dismal negative total return of minus 2.6% so far this year. The spread of corporate bonds as a share on their total yield reached the lowest level in a decade.
Bond funds are feeling the effects, as investors pull back and retreat in the face of negative total returns. The new reality is that corporate bonds no longer provide investors with a cushion against an adverse yield curve.
The price of bonds has been somewhat erratic this year. Since they are characterized as “riskless investments,” during times of uncertainty about interest rates, economic indicators — particularly the monthly jobs report — as well as any adverse geopolitical or domestic news, investors tend to flock to Treasuries for their steady interest payments and zero credit risk. However, if fears quickly become tempered, demand for bonds can suddenly diminish.
Investor sentiment this year, at times, has been as mercurial as the market. In the face of perceived bad news, some investors have panicked and overreacted, suddenly shifting the mix of their portfolios. These frequent and harried reactions, particularly in response to pronouncements by the Fed and inflation projections, have had, however imperceptible, a short-term effect on bond prices.
Another factor that is impacting the bond markets is partly psychological: A new narrative is being adopted that is radically different from the story of the past 10 years during a period of modest economic growth. Bond prices have now been especially sensitive to news about a trade war with China, inflation expectations and the response by the Fed in terms of whether rate increases will exceed their target of three for this year.
Should an upward trajectory of interest rates continue, corporate bonds may once again prove to be attractive investment, especially if the total return on the S&P 500 starts to stagnate.
I have no interest in any of the securities referenced in this article.
