The yield advantage of investment-grade and high-yield corporate bonds over government issues is now historically low relative to the past 25 years.
That may seem rather puzzling given where we are in the economic cycle. Leading indicators and the inverted yield curve – when short-term bonds yield more than long-term ones – are signalling an economic downturn ahead. Often, that would mean corporate bonds would have to offer larger payouts relative to safer government bonds to offset the risk that companies’ earnings could come under pressure and defaults might rise.
But we haven’t seen this so far, despite economic storm clouds on the horizon.
China, the world’s second-largest economy and its pre-eminent manufacturer and importer of materials, appears to be entering a disinflationary downturn. The country’s importance has grown rapidly in recent years.
Consider that during the Great Financial Crisis of 2008, China’s economy represented 7.2 per cent of world gross domestic product. Now it is 18.6 per cent. Meanwhile, the United States, which still represents about one-quarter of global GDP, has slowly been losing economic momentum. Europe is struggling even more.
If that wasn’t enough of a headwind for corporate bonds, earnings growth seems to be losing steam and may be declining. Heading into this earnings season, second-quarter profits for S&P 500 index companies were projected to be down 7.2 per cent from the same period a year ago, according to FactSet. That would mark the steepest decline since the second quarter of 2020, when COVID-19 shut down much of the world economy.
Earnings are a prime determinant of corporate cash flows, and cash flow relative to debt is a primary factor affecting credit quality. A company with high cash flow and low relative debt can weather tough economic times. One with low or negative cash flow and high debt won’t fare nearly as well, especially when it needs to roll over debt at higher interest rates. Indeed, the credit metrics of many companies are already slowly deteriorating.
I’m going to use U.S. investment-grade and high-yield bonds as examples, because the indexes there have relatively long histories, and they comprise more companies than Canadian indexes and have better industry diversification. Canadian and U.S. yield spreads also correlate highly enough to make analysis of American spreads a good proxy for investors on this side of the border.
The ICE BofA Corporate Index is currently trading only about 120 basis points higher than U.S. Treasuries, the safest credit instruments in existence. That’s not far from the lows over the past 26 years of 80 basis points.
But recent history shows how that spread can quickly blow out when the market is under stress. The spread reached 300 basis points early in the pandemic, when stock markets sold off. It was an astonishing 640 basis points in November, 2008, during the Great Financial Crisis. And it was 250 basis points in October, 2002, after a relatively mild economic downturn.
Now for high-yield corporate bonds. The ICE BofA U.S. High Yield Index spread is currently 390 basis points, which is near post-2008 lows. It was almost 900 basis points during COVID-19 lockdowns and reached a mind-boggling 2,000 basis points in 2008.
Bond yields and prices move inversely. So, when these spreads widen out, it means underperformance for corporate bonds relative to government issues. Clearly, economic downturns are not good times for corporate bond investors as the flight-to-quality trade is all on the sell side.
Keep in mind that the bond market is largely driven by institutional investors. Individual investors have little effect on prices and spreads other than when they sell in a panic during crises.
But individual investors can take advantage of buying opportunities after violent moves in spreads occur.
Key to this is understanding that the pressures on institutional bond managers are nuanced. Being overweight corporate issues will result in superior performance relative to competing managers and to indexes most of the time, and that is what leaders of institutions demand. Underperforming managers, at best, lose their bonuses, and at worst, their jobs. Fired underperformers have a hard time finding new positions.
When spreads suddenly widen out, managers who are overweight in corporates can give up years of outperformance and can see their relative performance drop from superstar status to the bottom of the ranking. Many an “award-winning” manager tumbles to dramatically below average.
I always get a good chuckle when I go to websites of investment firms that proudly crow that they are “award-winning” asset managers, yet fail to mention that their era of success has long passed. Also, if an investment company markets enough funds, it will almost certainly have some top performers, even by fluke.
When credit crises hit, corporate bonds become illiquid and managers sell in a panic. That is why spreads can explode so seemingly irrationally. Also, many investment-grade bond funds are compelled to sell issues that have fallen below a BBB rating to become high-yield or “junk.” This puts tremendous pressure on spreads.
Right now, corporate spreads relative to government bonds are low historically, despite an uncertain economic outlook. Perhaps it is because some economic data appear benign. But it is like this every time before a major sell-off in bond markets.
How bad can it get? Looking at history and using current levels as a guide, corporate spreads could rise at least two percentage points.
For a 10-year government bond, that means it would outperform corporates with a similar term by almost 20 per cent.
My advice: Avoid corporate bonds for now in favour of government issues. There will be an opportunity in the near future to buy corporates, after their yield advantage improves dramatically.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.