The $1.5 trillion Tax Cuts and Jobs Act of 2017 is expected to bolster corporate earnings, making corporate bonds attractive additions to a balanced portfolio, but there just so happens to be some d other reasons to be optimistic – and cautious – about these investments.
Lower corporate tax rates immediately increase cash flow, which can be used to reduce debt, invest in new equipment or hire more employees, says Nichole Hammond, senior portfolio manager at Angel Oak Capital Advisors. in Seattle. This improves the credit quality of the company and the bonds it issues to grow.
And with the current long-running bull market set to undergo more corrections, the value of corporate bonds should rise as stocks fall, says Scott Haley, founder of Prelude Financial in Wadsworth, Ohio. A declining stock market would lead investors to seek safety in bonds, which could drive bond prices higher.
This is the reverse of what is happening now. A booming stock market and economy prompted the Federal Reserve to raise interest rates, and more hikes are expected this year. Rate hikes haven’t done the broader bond market a favor (when rates rise, bond prices fall), but moving more of your holdings into fixed income is now a defensive move smart.
“A prudent investor should lock in gains from equity holdings and invest more in fixed-income investments such as corporate bonds,” Haley said. “If we look back to the 2008 recession, we can see that investors who had a larger portion of their portfolio invested in bonds actually performed well and saw positive gains while the majority of investors lost.
“It’s a self-correcting mechanism that, if timed well, can generate handsome returns for an investor if they diversify their portfolio ahead of a market correction or recession,” Haley said.
But the corporate bond market has grown dramatically in size and complexity over the past decade, according to a report from the Wells Fargo Investment Institute. While investment grade corporate bonds offer “attractive yields”, investors should stick to the fundamentals and be selective. Here’s how.
Look for high-quality, short-term maturities. Because of the effect that rising interest rates have on corporate bonds, the Wells Fargo Investment Institute recommends broadly diversifying them with other securities and reducing overall exposure to high-yield bonds.
Businesses often take advantage of debt to grow, and rising interest rates could make that debt more expensive. About 10% of corporate debt has variable interest rates and would become more expensive if rates rose, according to the Securities Industry and Financial Markets Association.
Watch the federal deficit. The Congressional Budget Office projects the budget deficit to grow from $665 billion in 2017 to around $1 trillion in 2019 and $1.5 trillion in 2028. If gross domestic product does not accelerate as rapidly, it could be a significant increase in interest rates to attract financing, Hammond said. Higher rates increase the cost of credit for businesses and consumers, which could slow the economy.
Beware of “fallen angels”. A fallen angel is a bond that used to have an investment grade credit rating, defined as BBB- or better, and has since been downgraded to high yield, defined as BB+ or less, due to weakening financial or market conditions. too much debt on the issuer’s balance. spreadsheet, says Greg Handel, senior portfolio manager at Tortoise in Los Angeles.
Since the financial crisis, corporate America has gone on a “borrowing spree,” driving average high-quality debt to a post-crisis high of nearly three times a company’s annual earnings before interest, taxes. , depreciation and amortization (EBITDA). Although highly leveraged companies are riskier, the interest rates they pay to bondholders have not kept pace and are at post-financial crisis lows, Handel said.
The Tax Cuts and Jobs Act also reduced a company’s deductible interest expense from 100% to 30% of EBITDA in five years. This will reduce free cash flow for heavily indebted companies to service their debt, particularly if interest rates rise significantly, Hammond said.
Choose your industry carefully. Highly leveraged debt often “hides” in non-cyclical sectors such as health care, food and beverage, telecommunications, media, cable and technology, Handel says. These sectors tend to borrow heavily to acquire other companies.
Handel cites General Mills (ticker: GIS) as an example, which recently increased its leverage to about 4.5x in its acquisition of Blue Buffalo Pet Products. While companies can expect long-term success by taking on so much debt, “any corporate misstep, unforeseen competition or macroeconomic downturn or shock could derail their ambitious deleveraging plans, which in most cases have virtually zero margin for error,” says Handel.
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Always diversify. Corporate bonds are an essential part of diversified fixed income allocations, says Dan Eye, senior portfolio manager at Roof Advisory Group in Harrisburg, Pennsylvania. High-quality corporate bonds offer investors more attractive interest rates or yields than ultra-safe US government-issued bonds, but also carry a higher risk of default.
It is widely said that the spread between government bonds and corporate bonds is narrower than it should be and therefore corporate bonds are overvalued, says David W. Barnett, owner of Grand Arbor Advisors in Fort Worth, Texas. “I tend to view this spread more positively,” he says. “To me, that means the market is pricing a much lower risk of default than what we’ve seen historically.”
However, to hedge this risk, spread your money across a large number of companies or sectors. Exchange-traded funds and mutual funds offer investors broader exposure to a greater number of companies.
Weigh the risks. Long-term bonds in a rising rate environment may actually carry more risk than stocks, says David S. Thomas Jr., CEO of Equitas Capital Advisors in New Orleans.
A 10-year bond at 2% has a duration risk of eight, he says. This means that for every 1% increase in interest rates, the value of the bond decreases by 8%. “Investors haven’t seen this environment for 30 years and are only just beginning to see it now,” Thomas says. “Most don’t know what to do.”
Barnett is cautious about tying up money for the long term as interest rate risk is more pronounced. “The sweet spot in the bond market right now is the average maturities of seven to 15 years,” he says.
For long-term investors, companies bonds may not be the best choice over stocks anyway. At the start of the year, AT&T 10-year bonds were yielding 2.5%. A $100,000 investment in the bonds would earn $25,000 in interest over 10 years and return your principal.
The same investment in AT&T (T) stock pays a 5% dividend, earning you $50,000 in dividends over 10 years. Of course, you don’t know what the stock will be worth a decade from now, but the stock price would have to drop 25% before it breaks even on the bond, Thomas says.
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