With rates rising, fixed income investors have found solace in a variety of shorter-termed securities. T-bills, certificates of deposits (CDs), and even cash are now paying rates of interest not seen in decades. As such, investors have broadly ignored a variety of other fixed income asset classes to focus on these new opportunities.
Thrown to the wayside has been bread & butter: corporate bonds.
And that’s a shame. Investment-grade corporate bonds—not the junk kind—offer plenty of benefits for portfolios as well as strong yields. With discounts growing on these IOUs, investors may have an opportunity to load up on some yield and potentially position themselves for gains down the road.
Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.
A Big Sell-off
Bonds issued by firms like Microsoft or Coca-Cola have formed the backbone of many fixed income portfolios for decades. And it’s easy to see why. Investment-grade corporate bonds feature stability of coupon payment backed by strong cash flows and a steadily growing earnings picture. But because Coca-Cola doesn’t have the ability to print money or raise taxes to pay its debts, investors are able to get a slightly better yield from IG corporates than they are from U.S.-backed Treasury bonds. That’s without taking on that much more in real credit risk.
However, the last year wasn’t too kind to corporate bonds.
As the Federal Reserve raised rates, corporate bonds felt the same pain as their Treasury cousins. With fears of recession looming—poor economic health impacts whether or not a firm can repay its bonds—major indexes of corporate bonds sank heavily last year. The Intercontinental Exchange’s index of investment-grade corporate bonds fell by 15% in 2022. That’s actually worse than ICE’s measure of junk/below-investment-grade debt.
All in all, investors pulled a record amount of cash out of investment-grade corporate bond funds, preferring short-term Treasuries and cash to take advantage of the rise in interest rates.
A Potential Big Bargain
However, in that sell-off and continued avoidance, investors may have a real opportunity to add some diversification and higher yields to their portfolio.
Starting with that yield, corporate bonds are paying some of the juiciest distributions in decades. At 5.7%, the Intercontinental Exchange’s index of investment-grade corporate bonds is paying the highest rate since 2008/09 credit crisis. This compares to about 3.57% for a 10-year Treasury bond and 4.8% for three-month T-bill. Here again, investors are able to get more yield without taking on much more risk.
Speaking of that risk, corporate health remains strong. Many firms issued debt during the low-rate days to beef up balance sheets and reduce their own costs of capital. With cash balances high and firms taking a pause from issuing new debt at higher rates, investment-grade corporates have gotten that much better. Upgrades from the ratings agencies have been swift in recent quarters.
In addition, there is plenty of potential for gains and snap-back to premiums with regard to investment-grade corporates. Unlike Treasuries, where interest rate risk is the only driver of returns, corporate bonds also have credit events tied to the individual company. Despite the economic picture, earnings have been good and have mostly beaten analysts’ estimates. This is a net positive for corporate bonds no matter what interest rates are doing. And because of this, individual corporate bonds provide a different set of diversification for a bond portfolio.
And finally, interest rate risk may be softening. While the Fed has agreed to raise rates further, the pace of its increases has surely slowed. And with inflationary data still on the downtrend and issues such as the banking crisis now starting to grow, the Fed has potential to pause rate hikes. This makes higher yielding corporates a very good deal.
Making a Corporate Bond Play
Given the higher yields, reduced risk, and diversification benefits of corporate bonds, investors may want to increase their holdings of these securities. You can certainly do far worse than owning bonds issued by Apple or Walmart. The best part is getting your hands on investment-grade corporate bonds is incredibly easy. Any good bond desk or brokerage firm will allow you to buy IG bonds with ease.
For those looking for funds, there are numerous low-cost ETFs that track the bond segment. For example, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) and Vanguard Total Corporate Bond ETF (VTC) are the gold standard when it comes to ETFs and offer broad exposure to the sector. However, there are numerous funds that cover everything from credit rating to duration exposure. For example, the SPDR Portfolio Short Term Corporate Bond ETF (SPSB) can be used to tap the shorter end of the spectrum.
With their performance as a portfolio allocation, investment-grade corporate bonds are also a fertile hunting ground for active managers. And investors may want to go this route. After all, many core index bond funds—particularly those that track the Bloomberg US Aggregate Bond Index—include a hefty slog of corporate bonds. By going active, investors can hone in on the best opportunities in the space. Keeping expenses low is critical to making active work, so focusing on low-cost funds is paramount.
The Bottom Line
As investors have moved into higher yielding cash and short-term bonds, investment-grade corporate bonds are looking pretty good. Yields are at decade highs and the overall risk picture is still good. For investors, ignoring corporates could be a bad idea. Luckily, there are easy ways to add them to your fixed income portfolio.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
