Low-Yield Blues? Corporate Bonds Are the Last Ones Paying
With bond yields falling further in the wake of Brexit, U.S. corporate bonds are the only game left in town
By Justin Lahart
The collapse in yields world-wide has left U.S. corporate bonds as one of the last places on earth to get relatively safe, steady income.
U.S. corporate bonds account for around 12% of all investment-grade debt outstanding world-wide, yet they now represent about 33% of investment-grade yield income, according to Bank of America Merrill Lynch credit strategist Hans Mikkelsen. Put another way, U.S. corporate bonds generate one out of every three dollars paid out by every government, business or fund that is considered investment-grade.
Like yields on government debt, the payouts on U.S. corporate bonds have fallen dramatically this year. The yield on the 10-year Treasury reached an all-time low of 1.36% Tuesday. Interest rates on 7-to-10-year bonds of high-quality U.S. companies are 3.14%, according to Bank of America Merrill Lynch. A year ago, those corporate bonds yielded 3.92%.
The relative attractiveness of U.S. corporate debt has drawn in billions of investor cash. That could be a boon for American businesses who can borrow almost unlimited amounts at almost unheard of rates, potentially boosting share buybacks, deals and, possibly, investment.
It’s a situation that has arisen as a consequence not of what investors expect from the U.S. economy so much as of the fresh rounds of stimulus from global central banks. Even though the Federal Reserve stopped buying Treasurys in 2014, both the European Central Bank and the Bank of Japan have been vacuuming up government bonds. That has pushed European and Japanese yields lower, and made U.S. bonds a relative bargain.
Government bonds still dominate the investment-grade bond market but the importance of corporate bonds has risen dramatically. Five years ago, U.S. corporate bonds represented around 9% of outstanding investment-grade debt and 13% of yield income. A year ago, corporate bonds accounted for 23% of yield income.
U.S. corporate debt could get even more enticing for global investors in the months to come.
The drop in global demand that Brexit looks likely to spark has made it more likely that both the ECB and the Bank of Japan will step up bond purchases.
For the ECB, those purchases include corporate bonds, which it began buying last month. It may need to buy even more of them, if only because it is at risk of running out of government debt that, absent rule changes, it can purchase. As it stands, it can only buy debt with yields above the ECB’s negative 0.4% deposit rate. On Tuesday, German benchmark bunds with maturities of less than nine years had yields below that cutoff.
The Bank of Japan might also consider broadening its corporate bond purchases in order to avoid owning too large a share of the Japanese government-bond market.
Such possibilities will drive more global investors into U.S. corporate bonds, driving yields lower and cutting borrowing costs for U.S. companies. That sets the stage for a pickup in debt issuance from the first half, when, according to Dealogic, U.S.-marketed investment-grade corporate-bond deals came to $441 billion versus $463 billion in the same period a year earlier.
For investors, the low yields mean they are getting paid less for the risk they are taking with bonds that, while safe, are riskier than government debt. It’s hard to say whether investors are underpricing risk, just as they did before the financial crisis. But if there were an economic downturn, or even a disruption in a specific industry, investors could be facing big, unexpected losses. The recent wipeout in the energy market is evidence that can happen quickly.
While investors could balk at the low yields, they don’t have many alternatives to get some income, at least for the foreseeable future.
So companies may soon be provided with more ammunition. Maybe, with the job market tightening and wages picking up, they will invest in new, more productive equipment in an effort to save on labor costs. Or even new projects.
If they choose the latter, it could spur the growth that central banks have been hoping for as they have driven down yields to spur more risk-taking. The reality is, rates for corporate borrowers have been extraordinarily low for years, so the latest leg down is unlikely to produce a wave of investments.
Instead, with investors’ hunt for yield in a low-rate world getting even more intense, companies are more likely to make their shares even more “bond-like.” That would argue for them using cash raised in the debt market to buy back shares and fund dividend payments. The result could be a fresh pile of debt on corporate balance sheets with ultimately little to show for it.