With 10-year Treasuries yielding 1.31% as of Aug. 27, it'd be reasonable to assume the 30-day SEC yield on the Markit iBoxx USD Liquid Investment Grade Index is “attractive.”
It is...sort of. Obviously, in sheer yield terms, 2.09% is higher than 1.31% and the yields on relevant junk bond indexes are even higher, but some investors aren't taking the bait. Year-to-date, no exchange traded fund experienced greater outflows than the fund tracking the Markit iBoxx USD Liquid Investment Grade Index and two of the other nine worst offenders are the two largest junk bond ETFs.
ETF flows don't always paint the full picture of a specific asset class, but it is interesting, if not confounding, that against the backdrops of low government bond yields, a strong economy and modest default rates that market participants are abandoning corporate bonds, including investment-grade fare.
Corporates Betraying Favorable History
The Markit iBoxx USD Liquid Investment Grade Index is off 1% year-to-date and while that's by no means an alarming loss, it is confirmation investment-grade corporates are betraying what was a favorable track record in low-yield environments.
“As yields trended lower over the last decade, investment grade bonds have offered investors reasonable yield of approximately 3%, relatively low risk of principal loss, and attractive total returns of just over 5% annualized,” according to BlackRock. “Today, despite a favorable growth backdrop and expectations for low defaults, we believe the risk-adjusted reward in investment grade is increasingly unattractive.”
Making matters even harder on fixed income investors today is that credit spreads – the yield compensation derived for taking on risk above Treasuries – is low, implying that risk isn't being adequately compensated.
“The all-in yield on any corporate bond has two components: rates and an additional spread to compensate for risks such as credit risk and lower liquidity. Today, both components are at historically low levels, resulting in an all-in yield of just 2% for the Bloomberg Barclays US Corporate Index,” adds BlackRock.
Factor in inflation, the possibility of rising interest rates and modest return forecasts for investment-grade corporate debt over the next few years and it's possible the asset class will actually deliver negative performance in real terms.
Story Gets Worse, not Better
If an investor focuses solely on what's happening today, the outlook for investment-grade corporate bonds should be bright. As noted above, the economy is sturdy and default rates are low. Additionally, many S&P 500 companies are flush with cash, indicating concerns are debt servicing are minimal.
However, a broader view is necessary and it shows that, broadly speaking, things aren't trending in the right direction for investment-grade corporates regarding both credit risk and rate risk.
“When making historical comparisons, it’s important to consider how things have evolved compared to past periods,” notes BlackRock. “With respect to investment grade, the story isn’t a good one. Over the last 15 years, we have seen the maturity profile of the investment grade sector lengthen, which has led to greater interest rate risk. This means that investment grade bonds are even more sensitive to changes in interest rates than they have been historically.”
Add to that, the percentage of BBB-rated bonds – the last notch before junk – in the investment-grade space is increasing. It's at 51% today, up from 35% 15 years ago while the number of bonds rated AAA, AA or A dwindled over that period.
All of that is to say that when it comes to income today, advisors might want to extol the virtues of other asset classes to clients.
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