Sluggish economic growth and the threat of deflation drove global government bond yields to record-l...
Sluggish economic growth and the threat of deflation drove global government bond yields to record-low levels in mid-June.
Since then, however, yields have soared, as better-than-expected economic news and reasonably positive quarterly earnings reports have encouraged investors to shift their attention to equities.
And they are likely to rise further because of the monetary and fiscal measures in the US. What does that mean for the corporate bond sector? Essentially, there are two key risks associated with corporate bonds: default risk and duration risk.
Default risk is the probability that a bond issuer will be unable to meet coupon payments or repay the principal. Unsurprisingly, it increases during economic downturns. Duration risk is a bond's sensitivity to changing interest rate expectations; it comes to the fore when economic growth is recovering and interest rates are rising.
In recent years, deteriorating economic prospects, the threat of terrorist attacks and high-profile corporate scandals meant default risk was investors' main consideration. Consequently, they flocked to risk-free government bonds and top-rated corporate bonds. The latter, in addition to their low default rates, also offer the longest duration (around eight years) among corporate bonds.
This was beneficial when yields were falling, and helps to explain why AAA-rated bonds outperformed lower-rated bonds by a significant margin last year. Earlier this year, however, as government bond yields sank to record low levels and top-rated corporate bond spreads contracted sharply, investors were forced to increase their exposure to lower-rated bonds to maintain their yield.
As a result, the year-to-date returns on BBB-rated bonds are three times higher than those rated AAA and the high-yield (sub-investment grade) sector has performed better still. Duration on lower-rated corporate bond funds and blended funds (those that combine various fixed-interest assets) is around six years and around four years for high-yield bonds.
With yields expected to rise further, lower-rated, shorter-duration corporate bonds will continue to offer the most attractive returns for investors. Needless to say, their higher (albeit falling) rates of default means that stock selection will remain important. For although the economic outlook is improving, there are still some structural economic factors that could make it difficult for some companies to grow. Several key industries, notably autos and airlines, are struggling with vast overcapacity.
And consumer spending is likely to slowdown, constrained by a cooling housing market and already high personal indebtedness levels. Therefore, pricing is likely to remain under pressure, making it difficult for companies to grow their revenues. Significant cost-cutting has already helped them to protect their profits, but they will not be able to rely on this forever.
Avoiding weaker sectors and focusing on the strongest companies will be an important determinant of investment success ' albeit secondary to a short duration strategy.
Lower-rated bonds will provide best returns.
Duration will be a key driver of performance.
Improving economy should drive down risk.
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