Corporate bond investments have posted some of the strongest returns in the fixed income universe so far in 2023, but it might be difficult to replicate that performance next year. Positive total returns seem likely, but excess returns—returns relative to Treasuries—might not be as high.
We continue to suggest an "up in quality" theme, as we expect economic growth to slow, and as we outline in our broad 2024 outlook, the path of interest rates is likely to be a rocky road. The path of corporate bond yields should be a rocky road, as well.
The Bloomberg US Aggregate Index was able to eke out a positive year-to-date total return through the end of November, but that performance didn't necessarily live up to this year being "the year of the bond" as many had hoped. The return has been less than the index's average coupon rate to start this year. Corporate bonds did deliver, however, with the lower-rated, higher-risk bonds posting the highest total returns. Investment-grade corporate bonds comprise about a quarter of the Aggregate index, but high-yield corporate bonds are not included in the Agg.
Low-rated, high-risk bonds have led the way this year
Source: Bloomberg. Total returns from 12/31/2022 through 11/30/2023.
Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Indexes representing the investment types are: Morningstar LSTA Leveraged Loan Index, Bloomberg US Corporate High-Yield Bond Index, ICE BofA Fixed Rate Preferred Securities Index, Bloomberg US Floating Rate Notes Index, Bloomberg US Corporate Bond Index, and the Bloomberg US Aggregate Index. Past performance is no guarantee of future results.
Consistent with our "up in quality" theme for 2024, we believe that it makes sense to take additional risks only if you're compensated appropriately, but that's not necessarily the case today. The extra yields that corporate bonds can offer relative to comparable Treasuries—that extra yield is known as a "spread"—are well off their recent highs and remain below their long-term averages.
Now those spreads make up a shrinking share of corporate bonds' average yields, especially as Treasury yields have risen so much. The chart below illustrates the average spread of each index as a percent of the yield of the index. The measure is low for both investment-grade and high-yield corporate bonds, recently falling to the lowest levels since 2007. Overall corporate bond yields are high and look attractive, but the extra yield investors get to compensate for the risk of lending to corporations is low.
Corporate bond spreads represent a relatively low portion of the overall yield offered
Source: Bloomberg, using weekly data as of 11/30/2023.
Bloomberg US Corporate Bond Index and Bloomberg US Corporate High-Yield Bond Index. Lines represent the average option-adjusted spread (OAS) of each index divided by the average yield-to-worst of each index. The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return—typically, a comparable Treasury security yield—which is then adjusted to take into account an embedded option. Yield-to-worst is the lowest possible yield that can be received on a bond with an early retirement provision. Past performance is no guarantee of future results.
"Up in quality" doesn't mean investors need to avoid all corporate bond investments. We just don't suggest overweighting them right now. We're still concerned that slower economic growth could pull down corporate bond prices relative to Treasuries, especially if the default rate continues to rise. But so far that hasn't happened yet, as the economy has proven more resilient than expected despite the aggressive pace of Federal Reserve rate hikes.
The aggressive pace of Federal Reserve rate hikes means higher borrowing costs for corporations looking to issue or refinance maturing debt, but corporate fundamentals have generally held up. Corporate profits, as measured by the Bureau of Economic Analysis, have held in a tight range since the end of 2021. While corporate bond investors would prefer to see rising profits, flat profits might be good enough keep corporate bond prices supported next year.
U.S. corporate profits have held steady for a number of quarters
Source: Bloomberg, using quarterly data as of 3Q2023.
US Corporate Profits With IVA and CCA Total SAAR (CPFTTOT Index). Past performance is no guarantee of future results.
There are risks, of course. While profits have held steady, corporate defaults continue to pile up. There are a few ways a company can default, but a common reason is that it failed to make interest payments or return the principal amount as scheduled, and it usually results in a loss in value for bond holders. According to Standard & Poor's, the trailing 12-month speculative-grade corporate default rate rose to 4.1% in September 2023, after hitting a low of just 1.3% in April 2022. That default rate is expected to rise to 5% by the third quarter of 2024, as corporations struggle with the rising borrowing costs.1
In line with rising defaults, there have been significantly more downgrades than upgrades in the high-yield market this year. Investment-grade corporate bonds have seen more upgrades than downgrades, but only by a slim margin. This trend may continue as rising borrowing costs tend to impact the lower-rated, highly leveraged companies more than those with investment-grade ratings.
S&P ratings actions
Source: Bloomberg, with data from Standard and Poor's.
Rating actions from 1/1/2023 through 11/30/2023.
Investment-grade corporate bonds continue to appear attractive, given their relatively high yields and low to moderate credit risk. There are risks, however, if the economy slows and spreads rise. It might be difficult for investment-grade corporates to outperform Treasuries next year, but positive total returns still seem likely.
The absolute level of yields is one of the key reasons why investors should consider investment-grade corporate bonds—the average yield of the Bloomberg US Corporate Bond Index closed November at 5.6%. While that's off its recent high of 6.4% hit in October 2023, a yield that high has rarely been seen over the last 14 years.
The slope of the yield curve is relatively flat, meaning investors don't need to sacrifice yield by considering intermediate- or long-term bonds the way Treasury investors do. Accepting a lower yield for a longer-term bond can be a tough concept to accept, but we still think it makes sense given our outlook for short-term yields to fall as the Fed likely pivots to rate cuts next year. Investment-grade corporate bond investors don't face that challenge, as the yield curve is relatively flat.
The investment-grade corporate bond curve is flat to positively sloped
Source: Bloomberg, as of 11/30/2023.
Columns represent the maturity-specified sub-indexes of the Bloomberg US Corporate Bond Index and the Bloomberg US. Treasury Index. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
Although yields are high, spreads aren't. The average option-adjusted spread of the Bloomberg US Corporate Bond Index closed November at just 1.04%, its lowest level since January 2022, and well below the 1.6% levels that were touched a few times over the last 12 months.
With spreads low, there's likely more room to rise than fall, but that doesn't mean investors need to shy away from investment grade-corporates. Over time, a rise in spread has generally been accompanied by a fall in Treasury yields. Because a corporate bond yield is composed of both inputs—the Treasury yield plus a spread—a rise in one but a fall in the other can mitigate the movements to a degree. That's important because bond prices and yields move in opposite directions, and rising yields pull down bond prices.
Going back to August 2000, we explored all instances where the average option-adjusted spread of the Bloomberg US Corporate Bond Index rose by 50 basis points or more. The time from the trough to the peak varied from as short as two months in early 2020, to as long as 22 months from early 2007 through late 2008. In each instance, we also looked the change in the index's yield-to-worst. In all but one instance, the yield rose by less than the rise in spread, and in a few instances the yield actually declined despite the spread increase. This relationship shows that spread movements don't happen in a vacuum, and a spread increase, if accompanied by falling Treasury yields, doesn't have to spell doom for corporate bond investors and can help keep corporate bond prices supported.
Over time large spread increases have generally been met with declining Treasury yields
Source: Bloomberg, as of 11/30/2023.
Past performance is no guarantee of future results.
Columns represent the change in option-adjusted spread and yield-to-maturity of the Bloomberg US Corporate Bond Index over the following periods: June 8, 2001 – November 2, 2001, May 31, 2002 – October 11, 2002, February 23, 2007 – December 5, 2008, April 8, 2011 – November 25, 2011, June 20, 2014 – February 12, 2016, February 2, 2018 – January 4, 2019, January 17, 2020 – March 20, 2020, and September 24, 2021 – October 21, 2022.
Investor takeaway: Investors looking to earn higher yields without taking too much additional risk should consider investment-grade corporate bonds. While slower economic growth does pose a risk to the market, we expect their prices to hold up better than the prices of high-yield bonds should growth slow.
Investor takeaway: Investors looking to earn higher yields without taking too much additional risk should consider investment-grade corporate bonds. While slower economic growth does pose a risk to the market, we expect their prices to hold up better than the prices of high-yield bonds should growth slow.
Investor takeaway: Investors looking to earn higher yields without taking too much additional risk should consider investment-grade corporate bonds. While slower economic growth does pose a risk to the market, we expect their prices to hold up better than the prices of high-yield bonds should growth slow.
High-yield corporate bonds
We continue to see risks with high-yield corporate bonds, but their high yields can't be ignored. The average yield-to-worst of the Bloomberg US Corporate High-Yield Bond Index is still near 8.4%, and the relatively high income payments they provide can serve as a buffer in case prices do fall.2
The concerns we have with high-yield corporate bonds are the same concerns we've generally held for the past year: the inverted yield curve, the rise in borrowing costs for highly leveraged companies, economic growth concerns, and the rising corporate default rate.
Those risks are still present today, yet spreads remain near their lowest levels of the past 18 months. We think it makes sense to take risk with lower-rated bond investments if you're being compensated for that risk, but with an average spread of just 3.7% for the Bloomberg US Corporate High-Yield Bond Index, that compensation is relatively low.
Bank lending standards can be a key driver of the economy because reduced bank lending, or tighter lending conditions, may mean less spending or investment by households or businesses. The most recent Senior Loan Officer Opinion Survey from the Federal Reserve showed that bank lending standards generally remain tight, albeit with some improvement since the prior release. In the past, when lending standards have tightened high-yield spreads have tended to rise. That hasn't really happened during this cycle.
Tighter bank lending standards have been accompanied by wider high-yield spreads in the past
Source: Bloomberg, using quarterly bank lending data as of 3Q 2023 and corporate spread data as of 11/29/2023.
Net % of Domestic Respondents Tightening Standards - C&I Loans for Large/Medium (SLDETIGT Index), Net % of Domestic Respondents Tightening Standards for C&I Loans for Small Firms (SLDETGTS Index), and Bloomberg US Corporate High Yield Average OAS (LF98OAS Index). Past performance is no guarantee of future results.
Despite our concerns, the high-yield bond market has been one of the best-performing fixed income asset classes this year, benefitting from both the relatively high income payments high-yield bonds provide and the decline in spreads. If our base-case outlook for slower growth and lower inflation, but no recession, comes to fruition, then high-yield bond prices may hold steady despite those tight spreads. The high-yield index has an average coupon rate of over 6%, meaning prices could fall by roughly 6% over a 12-month span and an investor may still break even.
Investor takeaway: We're still cautious on high-yield bonds, but acknowledge that if a recession is avoided, high-yield bonds may still perform well despite low spreads. Over the short run, expect volatility and potential price declines as defaults continue to pile up. Over the long run, the nearly 8.4% average yields they currently offer represent a high starting point for investors who plan to hold for the long term and can ride out the ups and downs.
Investor takeaway: We're still cautious on high-yield bonds, but acknowledge that if a recession is avoided, high-yield bonds may still perform well despite low spreads. Over the short run, expect volatility and potential price declines as defaults continue to pile up. Over the long run, the nearly 8.4% average yields they currently offer represent a high starting point for investors who plan to hold for the long term and can ride out the ups and downs.
Investor takeaway: We're still cautious on high-yield bonds, but acknowledge that if a recession is avoided, high-yield bonds may still perform well despite low spreads. Over the short run, expect volatility and potential price declines as defaults continue to pile up. Over the long run, the nearly 8.4% average yields they currently offer represent a high starting point for investors who plan to hold for the long term and can ride out the ups and downs.
Preferred securities
Preferred securities appear attractive for investors looking for higher income payments who are willing to ride the ups and down of the market. However, banking sector concerns may continue to weigh on the market. The coupon payments on many (but not all) preferreds are considered qualified income and are subject to lower tax rates than traditional interest income from bonds, so they also make sense for high income earners that are willing to take a little extra risk.
Preferred securities are a type of hybrid investment that shares characteristics of both stocks and bonds. Banks and other financial institutions are the most frequent issuers of preferreds, so average prices hit a cyclical low earlier this year when a number of banks failed. Although they have rebounded, they remain close to the more than 10-year lows, so the entry point remains relatively attractive.
Preferred prices have rarely been lower
Source: Bloomberg, using weekly data as of 11/30/2023.
Past performance is no guarantee of future results.
Despite the rebound from this year's lows, many preferred security prices have not recovered, especially those issued by small- and mid-size regional banks that haven't fully regained market confidence just yet. With that trend still intact, we suggest that investors who are considering preferreds favor those issued by larger banks that have been better able to withstand deposit flight and commercial real estate woes.
While yields remain high and prices remain low, relative valuations matter. Compared to triple B rated corporate bonds, the yield advantage that preferreds offer is near the lowest level since before the 2008-2009 global financial crisis. Preferreds tend to have credit ratings of BBB/Baa or the high rungs of the high-yield spectrum, like BB/Ba, so a comparison to the triple B rated corporate bond index is a more apples-to-apples comparison than the broad corporate bond index, half of which is rated single A or higher.3 (Note that preferred securities tend to have lower ratings than the same issuer's senior unsecured bond; a bank's bonds might be rated "A" but its preferred security could be rated BBB, since the preferred security ranks junior to the bond.)
The yield advantage that preferred securities offer relative to similarly rated corporate
Source: Bloomberg, using weekly data as of 11/30/2023.
ICE BofA Fixed Rate Preferred Securities Index and Bloomberg Baa Corporate Index. Past performance is no guarantee of future results.
Investor takeaway: Preferred security yields remain near their highest levels in more than 10 years, and the low prices make the entry point attractive for long-term investors willing to ride out some volatility. But the yields offered aren't much higher than those offered by similarly rated corporate bonds, so more conservative or moderate investors that are looking for more stability in their portfolios could focus on investment-grade corporate bonds, as they are generally senior to most preferred securities.
Investor takeaway: Preferred security yields remain near their highest levels in more than 10 years, and the low prices make the entry point attractive for long-term investors willing to ride out some volatility. But the yields offered aren't much higher than those offered by similarly rated corporate bonds, so more conservative or moderate investors that are looking for more stability in their portfolios could focus on investment-grade corporate bonds, as they are generally senior to most preferred securities.
Investor takeaway: Preferred security yields remain near their highest levels in more than 10 years, and the low prices make the entry point attractive for long-term investors willing to ride out some volatility. But the yields offered aren't much higher than those offered by similarly rated corporate bonds, so more conservative or moderate investors that are looking for more stability in their portfolios could focus on investment-grade corporate bonds, as they are generally senior to most preferred securities.
What to do now
Overall, we expect corporate bonds to deliver positive returns in 2024, but we remain cautious about the potential for a downturn in the economy to have a negative impact on lower-rated bonds. Long-term investors should focus on the yields offered by many of these investments, as they have rarely been higher over the last 14 years. With inflation falling and the Federal Reserve likely done hiking rates, the peak in Treasury yields is likely behind us. We continue to suggest investors gradually extend the duration of their bond portfolios to match their investing time horizon, and given the slowing in the economy and tight spreads, we suggest focusing on higher-rated corporate bonds and only consider adding riskier bonds in moderation.
1 Source: S&P Capital IQ, "Higher Rates For Even Longer Could Push The U.S. Speculative-Grade Corporate Default Rate To 5% By September 2024," November 16, 2023.
2 As of 11/30/2023
3 The Moody's investment grade rating scale is Aaa, Aa, A, and Baa, and the sub-investment grade scale is Ba, B, Caa, Ca, and C. Standard and Poor's investment grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C. Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. Fitch's investment-grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C.
