Abstract Background
Posted on JAN 17, 2019

When Corporate Bonds Are a Risky Investment

Bond Buyers are told to stay in the shallower end of the yield curve to avoid unnecessary duration risk in a low interest‐rate environment.

Less discussed are the credit quality of these investments. When interest rates are near zero, corporations and other entities pile on debt. The difference in yields between an investment‐grade credit and a junk bond aren't often much, making these slightly more fruitful junk bonds a bigger risk compared to the less volatile economic environment of the past.

But with the Federal Reserve raising interest rates, corporate‐bond risk is rising. The credit spreads are widening, measured by the difference between the yield of the U.S. 10‐year Treasury note and other fixed income securities.

It's becoming more expensive to issue new debt and the refinancing of older debt is costlier, and that's driving worries for some corporate bond market investors, says Jeffrey MacDonald, managing director and head of fixed income strategies at Fiduciary Trust Company International in New York City.

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

  • Market volatility affects companies' debt loads.
  • Nearing the end of the credit cycle.
  • Companies are a credit risk.

Market Volatility Affects Companies' Debt Loads

The safest investment, U.S. Treasury notes, are less risky with lower yields. In contrast, junk bonds can offer higher yields, as a reward for investors who are willing to accept the higher risk.

For example, the U.S. 10‐year Treasury note's yield was 2.7 percent while Moody's Seasoned AAA Corporate Bond Yield was 4 percent on January 16, 2019. Junk bonds, which carry a credit rating of BB or lower by Standard & Poor's, or Ba1 or below by Moody's, offered a higher yield; Moody's Seasoned Baa Corporate Bond Yield held a 5.17 percent yield on that day.

A volatile stock market and a slowing global economy increases worries that companies with heavy debt loads will struggle, potentially leading to credit downgrades and possible defaults. Market watchers say investors holding corporate bonds should review their holdings for duration and quality because of higher interest rates and stock market weakness. If it makes sense for the overall portfolio, bondholders should consider moving into short‐term bonds with higher credit quality, investing experts say.

Nearing the End of the Credit Cycle

Over the last 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 says.

“Not only has the size of the market increased and companies have borrowed a lot, but the overall quality on the ratings for the investment‐grade bond market has deteriorated as well,” he says. “So I would not be doing my job if I did not say that I have concerns.”

Brian Andrew, chief investment officer at Johnson Financial Group in Milwaukee, says the end of the credit cycle is near, given there have been meaningful changes in credit spreads. While some investors are worried about default risk, Andrew isn't yet. There could be a pickup 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 percent of equity.

MacDonald is watching General Electric (ticker: GE), which is struggling with debt. The conglomerate was a large debt issuer and there are some thoughts that GE's debt will be downgraded to junk status. That could have a ripple effect across the entire corporate bond market.

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

He says the situation needs to be watched, but he's not worried yet. MacDonald recalls when automakers like Ford Motor Co. (F) and General Motors Co. (GM) were dealing with debt downgrades, and there was concern that the less than investment‐grade market would be swamped with extra supply, but it went relatively smoothly. He notes that Ford eventually 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 the jitters in the stock market may be unnecessarily spilling over to bonds.

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

Jeff Mills, co‐chief investment strategist at PNC Financial Services Group in Philadelphia, says what may help the market are tempered expectations for 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.

Companies Are a Credit Risk

For investors thinking about shaking up their fixed income portfolio, they should look at the company's ability to pay back the debt and understand the firm's fiscal health, says Bryan Bibbo, lead advisor at The JL Smith Group in Avon, Ohio.

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

Investors can look at corporate bond yields by credit ratings from S&P and Moody's. However, he says, investors can do their own homework by reviewing a company's balance sheet, which will show the firm's liabilities, and the profit and loss statement.

“If they have $100 million in bonds they need to pay back, but they're only profitable by $10 million a year, it's going to take them 10 years to pay those back,” Bibbo says. “And that's without interest.”

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 to consider active management for that part of their portfolio.

Katsnelson says there are nuances to constructing passive benchmarks in high‐yield debt, which often have problems trading smoothly when markets go awry.

“We use more active management in that space because we've seen that to be the best way to avoid some of the major defaults, and you avoid some of the bigger names that are obvious (problems),” he says.

Individual investors who aren't going to be able to do their own in‐depth credit research should look for an active bond manager who holds credit ratings in the A to AA category, Mill says.

“On a daily basis, those folks are doing the work to make sure that the credits that are the portfolio aren't exposed to additional downgrade,” he says.

Article by Debbie Carlson | U.S. News & World Report