The
Attractiveness of Higher Risk Bonds in the Current Market
by Connor Darrow
In this current investment climate, it is hard
to predict the future. Investment diversification is crucial in such chaotic
times in order to mitigate risk. With weak stock performance to start the year
(S&P down more than 11% ytd), and uncertainty going forward,
diversification is all the more important.
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Therefore, bonds should be
considered as they can still generate a positive return even in weak economic
times. In consideration of the overall
economy, many companies have been put on hold amidst stay at home orders and a
nation-wide quarantine. As a result, companies have been forced to obtain debt
to cover their expenses while their revenues have decreased. This has led to a
larger supply of debt securities and has opened up increased buying
opportunities for investors, leading to a buyers’ market with larger than usual
yields given the lack of demand.
Furthermore, the Federal Reserve recently has
been contributing by not only buying risk free assets but now corporate and
even junk bonds! This has had the effect of lowering bond liquidity risk and
possibly credit risk should the government continue to buy lower credit bonds
in the case of default. The Federal Reserve’s intervention has made debt yields
more lucrative than usual. Thus, now is the time to consider increased bond
exposure - particularly core bonds.
With the decline of the US stock market and
the uncertainty of when business will go back to normal it is more important
than ever to remain diversified. It is critical to know that core aggregate
bonds, which are US investment grade bonds, are incredibly useful for when the
stock market drops (See chart below obtained from Barclays).
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With many bonds
having already fallen off from investment grade status, the credit risk is not
the same as it was before the coronavirus health crisis and should others fall
the Federal Reserve is helping to mitigate some of the loss here. Thus, while
the credit risk profile of companies in general has increased, the Federal
Reserve is now stepping into help as bonds have sold off leading to more
attractive discounted bond prices.
It is also important to consider that if one
is leery of core bond risk, two of the main alternatives are treasuries and
high yield debt. With treasuries trading well below 1% yield and high yield
debt companies not being able to operate and having already been just barely
getting by, the risk has increased in high yield investment. As a result, core
bonds easily stand out as a better option in my opinion. The chart below shows
recent stock weakness against the benefits of core bonds.
These events show the
core bond market can continue to make a profit even in weak economic times
which can help an investor hedge their portfolio by smoothing out investment
returns caused by owning a heavy concentration in stock. Given the ability for
core bonds to still make a return even in weak times, it makes sense to include
them in one’s portfolio.
As mentioned, the slowing of the world economy
has notably hurt many businesses. Specifically, industries such as travel,
entertainment, restaurants, etc.
have been hit the hardest.
With the pause on the economy and the lack of
revenues coming in, companies in general, particularly those in the previously
mentioned industries, have had to bring in increased debt to stay afloat. One
example in particular is Carnival (CCL), an international cruise line, which
recently offered $4 billion in bond offerings with a 12.5% coupon to draw in
investors.
With 12.5% coupons being offered by these higher risk companies who
are unable to operate during this time, these bonds will likely provide large
returns on invested capital assuming these companies stay solvent. Even if
these companies face financing issues, collateral could make a difference. CCL
for example still has $28 billion worth of ships and other assets which would
be used as collateral in the case of bankruptcy according to the Financial
Times. Thus, these types of returns seem very lucrative, so much so that CCL
has had an overflow of orders. There are several other distressed companies
that will likely make similar offers. Investing a higher allocation of one’s
portfolio here would make a lot of sense.
Before the corona pandemic, the Barclays’s aggregate
bond index, which is a commonly used fixed income benchmark among others, had
steadily increased BBB+ exposure as interest rates were low and additional
return could be gained by increasing the indexes risk profile (see figure below
obtained from American Century Investments). This sacrifice for yield though
increased the risk for credit default.
With the American economy being slowed
by the coronavirus, more and more bonds could lose their investment grade
status. Which would obviously impact the return on bonds negatively so this
risk should not be ignored. But the point remains for quality businesses,
investors should add risk to their fixed income allocation as businesses' need
for cash is more important than ever to stay afloat. Now is the time to
increase investment grade bond exposure as others avoid it in fear of bond
default - especially now with the Federal Reserve currently buying higher risk
bonds. With treasury rates close to zero there is only more incentive to add
bond risk. The Federal Reserve has noticed a lack of bond investment and has
begun buying lower credit bonds which should enhance bond returns and even
lower overall bond risk.
The rise in lower credit quality bonds in the
Barclays index led to Federal Reserve action as many companies that were
previously investment grade could potentially go out of business due to the
pandemic.
According to MarketWatch, the Federal Reserve plans to buy $750
million in corporate bonds with investment grades of at least BBB-/Baa3
(minimum investment grade ratings of Standard & Poor’s and Moody’s).
Additionally, the Federal Reserve plans to purchase recently downgraded bonds
from investment grade ratings as of March 22 or later that are now rated at
least BB-/Ba3. The Federal Reserve intends to do so via exchange traded funds
with the investment objective of exposure to US high-yield corporate bonds.
This should enable investors to feel less pain in their bond allocations as the
Federal Reserve takes unprecedented action to lower overall bond risk making
fixed income a better option than usual in my opinion.
To conclude, this current investment climate
is clearly uncertain and given the returns of bonds in weak economic times,
they are a worthy portfolio addition. With a wider selection of bonds to choose
from backed by collateral and the Federal Reserve, now is the time to consider
adding bond risk. This has led to outsized spreads as companies like CCL offer
12.5% coupons versus the near zero treasury return. Thus, now is the time to
consider increased bond exposure.
