Falling interest rates have pushed money into corporate bonds, but there may be further gains to be had
By Jon Sindreu
The hunt for yield is back with a vengeance and corporate bonds look to be among the biggest winners.
Investment-grade credit has returned 13% this year, according to the ICE Bank of America Merrill Lynch index, putting it on course for its best performance since 2009—itself a 14-year record. Last week, agricultural manufacturer John Deere sold 30-year bonds at an initial yield of 2.877%, a record low for the U.S. corporate market.
Economic worries are mounting, with manufacturers around the world buckling under a slowdown in Chinese imports. But for financial markets this has been offset by the pre-emptive actions of Western central banks, which are slashing interest rates again. As a result, 10-year yields on Treasurys and German bunds have dropped by more than a percentage point over the past year and now trade at 1.6% and minus 0.6% respectively.
Corporate-bond yields have followed, falling so far that some investors fear for the sustainability of the rally. In a yield-starved world, though, demand for these bonds—particularly the higher-quality ones—may not have run its course.
In Europe, which is particularly vulnerable to the slowdown, investors returned from summer vacation hungry for more. Investment-grade credit issuance totaled €23.5 billion ($25.9 billion) in the last week of August, data by JPMorgan Chaseshows—the heaviest week in 18 months. Large companies were able to sell bonds at negative rates, including industrial conglomerate Siemens ,which is facing a likely recession in its home market of Germany.
John Deere sold 30-year bonds at a record low for the U.S. corporate market. Photo: rick wilking/Reuters
Indeed, the premium that new issuers usually pay relative to bonds that are already trading has practically been erased in 2019. At the end of 2018, when fixed-income investors panicked and started dumping corporate debt, it came close to 0.25 percentage points.
Once the impact of lower rates is stripped out, though, the corporate-bond market is still pricing in concerns about the economy. This could present an opportunity for investors.
The risk premium at which U.S. investment-grade corporate bonds trade in secondary markets has actually been rising, and is now close to its turn-of-the-year peak, which itself was the widest since 2016. In Europe, this measure has stabilized at higher levels than has been the norm in recent years.
This is likely a sign that there are still some gains left for these markets as investors keep reaching for returns amid ultralow sovereign debt yields. In particular, the safest corporate bonds—those graded AAA or AA by credit-ratings firms—have underperformed their riskier peers in 2019, even though they are likely to be the first that are bought instead of Treasurys.
The bonds of Southern European governments are also the easiest alternatives to German debt.
Of course, spreads on corporate bonds will appear small if there is an outright recession in the U.S. and Europe, which would likely hit the creditworthiness of companies. However, debt levels remain below previous peaks and central bankers seem eager to keep unleashing monetary stimulus.
Will investors be more motivated by economic concerns, or rather by their need for income?
For the next few months, at least, the odds seem better on the latter.
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