2024 Mid-Year Outlook: Corporate Bonds

Our overall outlook and guidance is mostly unchanged:

• Investment-grade corporate bonds remain attractive given their average yields of 5% or more. We continue to suggest investors gradually extend duration with intermediate-term bonds, and investment-grade corporate bonds can make sense as investors can earn similar, or even higher, yields than with short-term alternatives.
• High-yield bonds and preferred securities can be considered by long-term investors who can ride out some volatility, but we wouldn't suggest large or overweight positions in either given the low yield advantage they offer relative to high-quality investments. Many preferred securities do offer tax advantages, however.

Corporate fundamentals remain solid

The resilient economy has been a key driver of the strong corporate bond performance to start the year. Despite concerns of rising borrowing costs given the aggressive pace of Federal Reserve rate hikes, corporate fundamentals remain solid.

Corporate profits remain elevated, although the first quarter of the year saw a modest decline from the all-time high reached in the fourth quarter of last year. This corporate profit data comes from the Bureau of Economic Analysis and represents a high-level view of corporate profits—large and small companies, public and private, and those with high credit ratings, low credit ratings, or no credit ratings at all. But in aggregate, corporate profits are high.

There can be pockets of weakness, of course—defaults have continued to rise among high-yield issuers, with the U.S. trailing 12-month speculative-grade default rate rising to 5.8% at the end of April, according to Moody's, up from roughly 1% just two years ago.¹ Investment-grade issuers rarely default, and the risk of an elevated default rate moving forward is one more reason why we're a bit cautious with high-yield bonds over the short run.

Corporate profits are still near the all-time high

Source: Bloomberg, using quarterly data as of 1Q2024.

US Corporate Profits With IVA and CCA Total SAAR (CPFTTOT Index). Past performance is no guarantee of future results.

Corporate balance sheets are relatively strong, as well. Corporate liquid assets continue to rise, which could help prop up companies should the economy slow and profits decline. According to the Federal Reserve, nonfinancial corporate businesses had roughly $7.9 trillion in liquid assets on their balance sheets at the end of the first quarter, a record high. Market-based investments were responsible for some of that increase, considering that U.S. equities have generally risen over the last year. Excluding corporate equities and mutual funds, liquid assets still made a new all-time high in the first quarter.

More importantly, liquid assets have risen relative to upcoming liabilities, as shown below. The ratio of liquid assets to short-term liabilities is just shy of 100%. In aggregate, corporations have almost $1 in liquid assets for every $1 of upcoming short-term liabilities, one more supporting factor should the economy slow and corporate profit growth stagnate or even decline.

Corporations generally have a lot of liquid assets on their balance sheets

Source: Bloomberg with data from the Federal Reserve's "Z1 Financial Accounts of the United States" report, using quarterly data as of 1Q2024.

FOF Nonfarm Nonfinancial Corporate Business Liquid Assets NSA (NFCBCBLA Index) and FOF Nonfarm Nonfinancial Corporate Business Total Short Term Liabilities NSA (NFCBTSTL Index).

Investment-grade corporate bonds

Investment-grade corporate bonds continue to appear attractive, given their relatively high yields and low to moderate credit risk.

Spreads remain low, however. Credit spreads are the extra yield that corporate bonds offer relative to Treasuries; the average option-adjusted spread of the Bloomberg US Corporate Bond Index was just 0.92% on June 14th, 2024, well below its long-term average (option-adjusted spread, or OAS, measures the spread of a fixed-income security rate and the "risk-free" rate of return—typically, a comparable Treasury security yield—which is then adjusted to take into account an embedded option). Low spreads can make outperformance relative to Treasuries more difficult to achieve, but we still believe positive total returns are likely over the next six to 12 months.

Yields remain high despite low spreads and the yield curve is less inverted than the U.S. Treasury yield curve, meaning investors don't need to sacrifice yield in intermediate- or long-term corporate bonds the way investors in Treasuries do. Income-oriented investors should consider investment-grade corporates given those features—holding Treasury bills or other short-term investments opens the door for reinvestment risk once the Fed begins to cut rates, while considering intermediate- and long-term bonds allows investors to have more certainty around the income earned over a specific period of time.

Intermediate-term investment grade corporates can offer yields as high as Treasury bill yields, or potentially even higher

Source: Bloomberg, as of 6/14/2024.

US Treasury Actives Curve (YCGT0025 Index) and USD US Corporate IG BVAL Yield Curve (BVSC0076 Index). Past performance is no guarantee of future results. For illustrative purposes only.

The average credit quality of the investment-grade corporate bond market has been improving as well. In the years following the global financial crisis, the share of BBB2 rated bonds steadily increased, rising from the 33% area all the way to 52% in 2021.

That has since reversed, with BBB rated corporates making up 47% of the Bloomberg US Corporate Bond Index, while the A rated bond share has increased to 45%. BBBs still make up the largest share compared to AAA, AA, and A rated bonds, but it's a step in the right direction, as the implied credit risk of the index is lower today than it was a few years ago.

The amount of "BBB" rated bonds has been declining

Source: Bloomberg, using weekly data as 6/14/2024.

Lines represent the amount outstanding of the A and BBB subsets of the Bloomberg US Corporate Bond Index as a percent of that overall index. Past performance is no guarantee of future results.

Investor takeaway:

Investors looking to earn higher yields without taking too much additional risk should consider investment-grade corporate bonds. Investment-grade corporates are one of our preferred ways to extend duration, as investors don't need to sacrifice much, if any, yield in intermediate-term maturities.

High-yield corporate bonds

We continue to see risks with high-yield corporate bonds, but their high yields can't be ignored. The average yield-to-worst of the Bloomberg US Corporate High-Yield Bond Index has been hovering in the 7.5% to 8% area for most of this year, and the relatively high income payments they offer can help serve as a buffer in case prices do fall.³

There are two key concerns with high-yield bonds today:

1. The aforementioned default rate remains elevated. Although corporations have generally weathered the rise in borrowing costs, high-yield issuers tend to have more refinancing risk than investment-grade issuers. High-yield bonds tend to have shorter maturities, so the longer the Fed holds rates high, the more exposed issuers are to higher refinancing rates.
2. Low spreads suggest that investors aren't being compensated very well given the risks involved with high-yield bonds.

The average option-adjusted spread of the Bloomberg US Corporate High-Yield Bond Index closed at just 3.2% on June 14, 2024, well below its long-term average of nearly 5% and close to the recent cyclical low reached in 2021. The chart below highlights how volatile spreads can be, and how they can rise during economic slowdowns or general "risk off" periods. When spreads rise, high-yield bond prices generally fall relative to Treasuries. With spreads so low, the prospects for capital appreciation relative to Treasuries are low, while there's plenty of room to rise should the economic outlook deteriorate.

High-yield bond spreads are low

Source: Bloomberg, using weekly data as of 6/14/2024.

The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return—typically, a comparable Treasury security yield—which is then adjusted to take into account an embedded option. Past performance is no guarantee of future results.

Spreads aren't quite below 3%, but they did dip that low earlier this year. The chart below highlights how rare a sub-3% spread is, falling that low just 7% of the time since the year 2000. Keep this in mind when considering high-yield bonds: While a 7.5% average yield might look high on the surface, much of that yield simply comes from the level of Treasury yields, while the risk premium is very low.

High-yield bond spreads have rarely been this low

Source: Bloomberg, using daily data from 8/15/2000 through 6/14/2024. Bloomberg US Corporate High-Yield Bond Index.

Investor takeaway:

We're still a bit cautious on high-yield bonds, but acknowledge that if a recession is avoided, high-yield bonds may still perform well despite low spreads. Over the short run, expect volatility and potential price declines as defaults continue to pile up. Over the long run, average yields of 7.5% to 8% represent a high starting point for investors who plan to hold for the long term and can ride out the ups and downs.

Preferred securities

Preferred securities, like high-yield bonds, have seen their relative yields fall over the last few years. While absolute yields remain high and prices remain low, relative valuations matter. Compared to triple B rated corporate bonds, the yield advantage that preferreds offer is near the lowest level since before the 2008-2009 global financial crisis. Preferreds tend to have credit ratings of BBB/Baa or the high rungs of the high-yield spectrum, like BB/Ba, so a comparison to the triple B rated corporate bond index is a more apples-to-apples comparison than the broad corporate bond index, half of which is rated single A or higher. (Note that preferred securities tend to have lower ratings than the same issuer's senior unsecured bond; a bank's bonds might be rated "A" but its preferred security could be rated BBB, since the preferred security ranks junior to the bond.)

The yield advantage that preferred securities offer relative to similarly rated corporate bonds is low

Source: Bloomberg, using weekly data as of 6/14/2024.

ICE BofA Fixed Rate Preferred Securities Index and Bloomberg Baa Corporate Index. One basis point is equal to one one-hundredth of 1%, or 0.01%. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

Despite the low relative yields, preferreds can still make sense for income-oriented investors who can ride out the ups and downs, and they can also make sense for investors in high tax brackets.

Many preferred stocks pay qualified dividends that are subject to lower tax rates than traditional interest income. Investors considering preferreds relative to other investments should always consider what type of account they'll be held in—taxable or tax-advantaged—and if held in taxable accounts, the after-tax yield.

Not all preferred stocks or securities pay qualified dividends—some pay interest—so it's important to know what you own and what the tax consequences are. Qualified dividends are generally taxed at 0%, 15%, or 20% rates, depending on income limits. Those lower rates can be an advantage for investors in high tax brackets.

The chart below compares preferred security, investment-grade corporate, and high-yield bond yields. Before taxes, preferreds offer yields between investment-grade and high-yield bonds. For investors in high tax brackets, preferreds can offer higher after-tax yields than high-yield bonds.

Preferred securities can offer tax advantages

Source: Bloomberg, as of 6/14/2024.

Indexes represented are the Bloomberg US Corporate Bond Index, Bloomberg US Corporate High-Yield Bond Index, and the ICE BofA Fixed Rate Preferred Securities Index. The after-tax column makes the following assumptions: Investment-grade corporate and high-yield corporates include a 37% federal tax, a 5% state tax, and the 3.8% net investment income tax (NIIT), tax. Preferred securities assume a 20% qualified dividend tax and the 3.8% NIIT. Past performance is no guarantee of future results.

Investor takeaway:

Preferred security yields are high, but relative yields are low. Income-oriented investors who can ride out the potential ups and downs can consider preferreds, especially if they are in a high tax bracket. More conservative or moderate investors that are looking for more stability in their portfolios could focus on investment-grade corporate bonds, however.

¹ Moody's Investors Service, "April 2023 Default Report," May 15, 2024.

² The Moody's investment grade rating scale is Aaa, Aa, A, and Baa, and the sub-investment grade scale is Ba, B, Caa, Ca, and C. Standard and Poor's investment grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C. Ratings from AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. Fitch's investment-grade rating scale is AAA, AA, A, and BBB and the sub-investment-grade scale is BB, B, CCC, CC, and C.

³ Average yield-to-worst of the Bloomberg US Corporate High-Yield Bond Index was 7.8% as of 6/13/2024.

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