Corporate bonds

Why corporate bonds are risky with higher interest rates | Obligations

Bond buyers are urged to stay at the shallow end of the yield curve to avoid unnecessary duration risk in a low interest rate environment.

The credit quality of these investments is less discussed. When interest rates are close to zero, companies and other entities go into debt. The difference in yield between higher quality credit and a junk bond is often not great, making these slightly more successful junk bonds a greater risk compared to the less volatile economic environment of the past.

But with the Federal Reserve raising interest rates, the risk in corporate bonds is increasing. Credit spreads are widening, measured by the difference between the yield of the 10-year US Treasury note and that of other fixed-income securities.

It’s getting more expensive to issue new debt and it’s more expensive to refinance older debt, which has some investors in the corporate bond market worried, says Jeffrey MacDonald, managing director and head of bond strategies at Fiduciary Trust Company International. At New York.

Here are some details on when investors should revalue their corporate bond holdings:

  • Market volatility affects corporate debt.
  • Approaching the end of the credit cycle.
  • Businesses are a credit risk.

Market volatility affects corporate leverage

The safest investments, notes the US Treasury, are less risky with lower returns. By contrast, junk bonds can offer higher yields, as a reward for investors who are willing to accept the higher risk.

For example, the yield on 10-year U.S. Treasuries was 2.7%, while the yield on Moody’s seasoned AAA corporate bonds was 4% on January 16, 2019. below by Moody’s, offered a higher yield; Moody’s Seasoned Baa Corporate Bond Yield held a yield of 5.17% that day.

A volatile stock market and a slowing global economy are increasing fears that heavily indebted companies are in trouble, which could lead to credit downgrades and possible defaults. Market watchers say investors holding corporate bonds should review their holdings in terms of duration and quality due to rising interest rates and weak equity markets. If it makes sense for the overall portfolio, bondholders should consider switching to shorter-dated bonds with higher credit quality, investment experts say.

Approaching the end of the credit cycle

Over the past 10 years, the size of the investment-grade corporate bond market with at least an A rating has doubled, and the size of the high-yield cohort within the investment-grade bond market has tripled, MacDonald said. .

“Not only has the size of the market increased and companies have borrowed heavily, but the overall quality of investment grade bond market ratings has also deteriorated,” he said. “So I wouldn’t be doing my job if I didn’t say I have concerns.”

Brian Andrew, chief investment officer at Johnson Financial Group in Milwaukee, says the end of the credit cycle is near, given that there have been significant shifts in credit spreads. While some investors are worried about the risk of default, Andrew is not yet. There could be a recovery in defaults, but he says overall corporate balance sheets are in good shape in terms of cash balances and the amount of interest expense as a percentage of equity.

MacDonald is monitoring General Electric (ticker: GE), which is struggling with debt. The conglomerate was a major debt issuer and some believe GE’s debt will be downgraded to junk status. This could have a ripple effect on the entire corporate bond market.

“If it’s a company that has $2 billion in debt, the market can handle a move to high yield, but when it’s an issuer like GE with hundreds of billions dollars of debt, it grabs attention and has momentum for the broader market,” he says.

He says the situation needs to be monitored, but he’s not worried yet. MacDonald recalls automakers like Ford Motor Co. (F) and General Motors Co. (GM) facing debt downgrades, and there were fears the lower-quality market would be swamped with additional supply, but it went relatively well. . He notes that Ford has finally returned to its investment grade status.

Warren D. Pierson, managing director and senior portfolio manager at Baird Funds in Milwaukee, says some of the concerns about corporate bond risk are overblown, also noting strong corporate balance sheets. He says jitters in the stock market could unnecessarily trickle down to bonds.

“A slowdown in earnings growth affects stock prices,” says Pierson. “But that really doesn’t paint such a dire picture for corporate bonds.”

Jeff Mills, co-head of investment strategy at PNC Financial Services Group in Philadelphia, said what could help the market are tempered expectations of further interest rate hikes from the Federal Reserve. . The Fed raised rates in December 2018, but the central bank may not be as aggressive with rate hikes this year.

Businesses are a credit risk

For investors considering revamping their fixed income portfolio, they should look at the company’s ability to service debt and understand the company’s financial health, says Bryan Bibbo, senior adviser at The JL Smith Group at Avon, Ohio.

“These bonds are not backed by collateral,” he says. “They are backed by the overall faith and integrity of these organizations.”

Investors can view corporate bond yields based on S&P and Moody’s credit ratings. However, he says, investors can do their own homework by looking at a company’s balance sheet, which will show the company’s liabilities, as well as the profit and loss account.

“If they have $100 million in bonds that they have to pay off, but they’re only making $10 million a year, it’s going to take them 10 years to pay them off,” Bibbo says. “And that is irrelevant.

Dmitriy Katsnelson, chief investment officer at Bronfman Rothschild in Rockville, Maryland, says investors who hold passive high-yield exchange-traded funds or other passive index funds should consider actively managing this part of their portfolio.

Katsnelson says there are nuances in constructing passive benchmarks in high-yield debt, which often struggles to trade smoothly when markets turn bad.

“We’re using more active management in this space because we’ve seen that’s the best way to avoid some of the major flaws, and you’re avoiding some of the bigger names that are obvious (problems),” he says.

Individual investors who won’t be able to do their own extensive credit research should look for an active bond manager who holds credit ratings in the A to AA category, Mill says.

“On a day-to-day basis, these people do the work to ensure that the credits that make up the portfolio are not exposed to further downgrading,” he says.