When selecting investment grade corporate bonds in the current rate environment, a common question is: ‘How much better can it get'?
Over the last 12 months, highly rated corporate bonds have clearly benefited from the flight to quality and a migration from equities and money funds into fixed income. However, is it too late to find relative value in high quality corporate bonds?
A strong case can be made that while the bargains are gone, highly rated corporate debt will likely be very much in demand in 2010.
In late 2008 and early 2009, corporate spreads to U.S. Treasuries were at historical extremes. During the last few months, spreads have settled into ‘normalized' ranges (see nearby chart of corporate spreads to Treasuries).
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Will normalized ranges continue to shift in favor of even tighter spreads and greater flows into corporate debt issues?
Many economists have opined that the credit crisis-induced volatility in 2008 and first half of 2009 was likely to be once-in-a-generation phenomena. After unprecedented Fed intervention in the credit markets, high quality corporate issues have gained favor with a wide range of investors.
However, a consequence of the fallout has been bloated government deficits worldwide. As a result, diversification out of government-backed debt may be increasing as bond investors seek opportunities in well-managed corporations with strong balance sheets.
Reducing sovereign credit risk has become a common theme as many portfolio managers see long-term risks in excessive portfolio concentration in any sovereign or government-backed issuer. Market participants are taking note that while a government can print money to pay its bondholders at face value, it cannot do so without raising the risk of future inflation and credibility as a debt issuer.
While high quality corporate bonds are not likely to yield less than their corresponding government bonds over extended periods of time, a recent report from Bianco Research in Chicago points out the following:
- A corporation's capital structure is not fixed and can mutate as needed. Debt at risk of default can be restructured, forgiven or converted into equity as the need arises and as bondholders consent.
- While a corporation has equity shareholders, a nation's citizens are stakeholders but not shareholders in the government. While citizens may be creditors, there is no possibility for conversion into equity interests.
- Many private corporations are quite simply better credit risks than many governments. Corporate entities cannot run open-ended deficits or engage indefinitely in money-losing operations.
For fixed income allocations, absolute interest rate levels may be a larger consideration than relative spreads. While outguessing the timing of the next round of Fed tightening may be doable for a few rock star portfolio managers, the timeless strategies of laddering maturities, credits, and industry sectors will serve most portfolios well.
Bond funds and bond ETFs are liquid and offer instant diversification for smaller portfolios. But for larger portfolios, individual bonds may be a better alternative for steady income and meeting defined goals.
Is it too late to participate in the spread tightening? Are yields too low, and too tight to Treasuries? Perhaps, but an equally good case can be made that the fixed income world will be adjusting to the credit crisis shock for many months to come, with highly rated corporate debt still a good relative value.
John Radtke is the president of Incapital LLC, a securities and investment banking firm based in Chicago. Incapital underwrites and distributes fixed income securities and structured notes through over 900 broker-dealers and banks in the US, Europe and Asia.
