2022 Corporate Bond Outlook: Focus on Income
It’s been a mixed bag for corporate bond investments this year. Investment-grade corporate bond returns have spent most of the year below zero, but riskier investments like high-yield bonds, bank loans, and preferred securities have not only posted positive returns, but have been some of the best-performing fixed income investments through mid-November.
While the returns varied, there was one common denominator: Coupon income was the main driver of total returns, not price appreciation. We expect that trend to continue in 2022.
Coupon payments have been a key driver of total returns this year
Source: Bloomberg. Total returns from 12/31/2020 through 11/12/2021. Indexes represented are the Bloomberg U.S. Corporate Bond Index (Investment Grade Corporates), Bloomberg U.S. Corporate High-Yield Bond Index (High-Yield Corporates), and the ICE BofA Fixed Rate Preferred Securities Index (Preferred Securities). Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.
The prospect of modest price declines doesn’t mean investors need to shun corporate bond investments as we approach the start of a new year, however. We suggest investors take a more cautious approach and not overweight any of the riskier parts of the market, while focusing on short- and intermediate-term maturities in the investment-grade corporate bond market to help limit the interest rate risk.
Positive outlook, but less-easy monetary policies pose a risk
We may sound like a broken record, but it’s important to point out that corporate fundamentals are strong. Corporate profits continue to rise, there are plenty of liquid assets on corporate balance sheets, and the number of corporate defaults has plummeted. Both Moody’s Investors Service and Standard and Poor’s are projecting that the downtrend in defaults will continue, with Moody’s projecting a trailing 12-month speculative-grade default rate below 2% by the end of this year, a rate not seen since 2015. Given the strong fundamentals, the amount of bond upgrades by the rating agencies has dwarfed the number of downgrades this year.
High-yield upgrades have significantly outnumbered downgrades this year
Source: Bloomberg, as of 11/15/2021. Columns represent the percent of upgrades and downgrades as a percent of all rating actions from S&P for U.S high-yield issues. November rating actions are as of 11/15/2021.
The slow withdrawal of easy monetary policies does pose a risk to the corporate bond markets—especially the riskier parts of the market like high-yield bonds and bank loans. Tighter financial conditions tend to lead to more volatility in the risky parts of the market and can potentially lead to price declines. The pace and magnitude of any Federal Reserve rate hikes will be important in 2022. If the Fed takes a patient approach to tighter policies, riskier bond investments may hold their value, but a faster pace of rate hikes could result in more volatility, wider credit spreads, and lower prices.
Overall, this makes us a bit more cautious about lower-rated investments like high-yield bonds and bank loans, but investors can still consider them in moderation. More importantly, if rates rise in 2022 as we expect, it should provide investors an opportunity to lock in higher yields than they’ve seen in over a year.
Below we’ll go over the various parts of the corporate market to highlight some areas of opportunity and some potential pitfalls.
Source: Schwab Center for Financial Research
Investment-grade corporate bonds
We suggest a neutral allocation to investment-grade corporate bonds, but favor a below-benchmark average duration.
Over the past few decades the average duration of the Bloomberg U.S. Corporate Bond Index has risen sharply, a trend that accelerated over the past few years. Duration is a measure of interest rate sensitivity—the higher duration, the more the bond or bond fund’s price will fall if its yield rises. A rule of thumb states that a bond’s price will fall by a magnitude of its duration (in percentage terms) for a given one percent rise in its yields. For example, if a bond has a duration of 5, and its yield rises—say, from 2% to 3%—then its price would theoretically fall by 5%.
The average duration of the Bloomberg U.S. Corporate Bond Index is now 8.7 which means that its price declines could be larger than the example above, and has been hovering near its all-time high of 8.9 for the past year and a half. That high interest rate sensitivity poses a risk to the broad corporate bond market given our expectation for the 10-year Treasury yield to rise to the 2% area next year.
The average duration of the corporate bond index remains near its all-time high
Source: Bloomberg, using weekly data as of 11/12/2021.
Rather than a broad, index-tracking approach to investing in corporate bonds, we suggest investors focus on those with shorter maturities that are less vulnerable to rising bond yields. The 1-5 year corporate bond index offers a yield of 1.28%, up from just 0.65% at the beginning of the year. While that’s still low by historical standards, it’s higher than what investors can earn with very short-term investments like Treasury bills or money market funds, and it’s close to double the yield that an index of 1-5 year Treasuries offers.
By investing in short-term corporate bonds, you can earn yields that are better than zero, while the low average duration helps mitigates the risk of rising yields.
Short-term corporates offer higher yields than comparable Treasuries
Source: Bloomberg, using weekly data as of 11/12/2021. Bloomberg U.S. Treasury 1-5 Year Bond Index (LTR1TRUU Index) and the Bloomberg U.S. Corporate 1-5 Year Bond Index (LDC5TRUU Index). Past performance is no guarantee of future results.
High-yield corporate bonds
With an average yield of just above 4%, it’s tough to even describe the Bloomberg U.S. Corporate High-Yield Bond Index as being “high-yield.” Credit spreads—the amount of additional yield that corporate bonds offer above Treasuries with comparable maturities—remain near their post-financial-crisis lows. In other words, you’re not being compensated very well given their more aggressive risk profile.
The average spread of the index is just 2.8%, a low not seen since the summer of 2007. In fact, going back to 2002, the average option-adjusted spread (OAS) of the high-yield bond index has been lower than the current level less than 3% of the time.
Spreads remain near all-time lows
Source: Bloomberg, using daily data as of 11/15/2021. Shaded areas represent recessions. Option-adjusted spreads are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan.
With spreads so low, total returns are likely to be relatively low going forward. There are two key components of high-yield bond total returns: coupon income and price appreciation or depreciation. Price appreciation is limited given the current level of yields. We expect Treasury yields of all maturities to rise modestly in 2022, and there is very little room for spreads to decline to offset that potential increase in yields. The average duration of the high-yield bond index is less than 4, significantly lower than that of the broad investment-grade bond index. If Treasury yields rise but spreads remain low, high-yield bond prices should hold their value better than the broad investment-grade corporate bond market.
Over time, starting with such low credit spreads has made it a bit difficult for high-yield bonds to outperform Treasuries. And while corporate fundamentals remain strong today, we do see risks on the horizon. Inflation remains elevated, potentially eating into corporate profit margins if companies can’t pass on all of the price increases to their customers. The environment of supply chain bottlenecks poses a risk to the high-yield bond market since these firms tend to have riskier operations already, and any hit to their cash flows can make it more difficult to service their large debt loads.
Finally, the prospect of less-easy monetary policies—but not policies that are necessarily “tight”—poses a risk to the junkiest parts of the market, as it can negatively affect their ability to get credit. As the Fed begins to slowly raise rates, that may result in a flatter slope of the yield curve. The yield curve today is still steep, with the difference between three-month Treasury bill yields and 10-year Treasury note yields sitting at roughly 160 basis points. But as that gap narrows, high-yield performance can suffer compared to Treasuries securities with similar maturities, as the table below illustrates.
Next year we believe that the yield curve could go through bouts of steepening from time to time, but the long-term trend is likely a flatter yield curve.
A flatter yield curve tends to coincide with lower total returns
Source: Bloomberg. Relative returns compare the average 52-week total returns of the Bloomberg U.S. Corporate High-Yield Bond Index and the Bloomberg U.S. Treasury 3-5 Year Index depending on the starting slope of the 3-month/10-year Treasury yield curve, using monthly data from January 1994 through October 2021. One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001. Past performance is no guarantee of future results.
Preferred securities should be considered for income-oriented investors. Like the rest of the bond market, preferred securities’ yields are low, and prices are high. However, there are few options that can offer such high coupon payments. The average coupon rate of the ICE BofA Fixed Rate Preferred Securities Index is 5.1%.
Banks and other financial institutions represent a large majority of preferred securities issuance, and they appear to be in strong shape. The economy is growing, and the slope of the yield curve is still positive, allowing banks to borrow at low rates and lend at higher rates. The most recent results of the Federal Reserve’s stress test were released in June and showed that the largest financial institutions could handle shocks to the economy.
Investors should brace for more volatility in 2022, however. So far, over the course of 2021, the average price of the index hovered between $104.2 and $108.1, the tightest trading range since 2015, but we don’t expect that trend to continue.1 If long-term yields rise as we expect and as the Federal Reserve policies become less easy, volatility may pick up and prices could edge lower. Just like with high-yield bonds, preferred securities tend to perform best when the yield curve is steep, so any flattening of the curve in 2022 could negatively impact preferred security prices and potential returns.
Another risk is turnover at the Federal Reserve Board of Governors. Randal Quarles’ term as vice chair for supervision ended in October, and no one has been nominated to take that role yet (Quarles still holds a position on the Board of Governors but announced that he will resign in December). The outlook for bank supervision is now an unknown. If the new vice chair for supervision pushes tougher regulations on banks, that could affect their ability to make capital distributions to its common and preferred stockholders.
All of this doesn’t mean you need to shed your preferred securities, though—just plan to hold them for a while to earn those higher income payments. Over a two-year investing horizon, preferred securities tend to generate positive total returns.
Preferred securities generally had positive total returns over 2-year investment horizons
Source: Schwab Center for Financial Research with data from Bloomberg. Rolling 24-month total returns of the ICE BofAML Fixed Rate Preferred Securities Index from January 1992 through October 2021. Total returns assume reinvestment of income payments and capital gains. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
Bank loans are a niche part of the bond market but can help investors looking for higher yields today. Because of their sub-investment-grade or “junk” ratings, they should always be considered aggressive investments.
Given their aggressive risk profile, it’s often appropriate to compare bank loans to high-yield bonds, and today bank loans appear a bit more attractive.
While they both have junk ratings, bank loans rank higher than high-yield bonds, and bank loans are backed by a pledge of the issuers’ assets. While that might not necessarily prevent a bank loan issuer from defaulting, it usually means that investors receive a higher recovery value in the event of a default. Finally, bank loans have floating coupon rates, which reduces their interest rate sensitivity.
Adding it all up, bank loans have less credit risk and less interest rate risk than traditional high-yield corporate bonds, but investors aren’t sacrificing much in yield for those characteristics. The 4% average yield of the Bloomberg U.S. Corporate High-Yield Bond Index is just 10 basis points higher than the average yield of the S&P/LSTA Leveraged Loan 100 Index.
Bank loan yields are just below high-yield bond yields today
Source: Bloomberg, using weekly data as of 11/12/2021. S&P/LSTA U.S. Leveraged Loan 100 Index (SPBDLLY Index) and Bloomberg U.S. Corporate High-Yield Bond Index (LF98TRUU Index). Note that the yield for bank loans is the weighted average yield and the yield for high-yield corporate bonds is the average yield-to-worst. Past performance is no guarantee of future results.
There are risks, of course. Like most bond investments, there’s little room for bank loan prices to rise from here, as the $98.7 average price of the index is just 50 cents below its five-year high. And while both bank loans and high-yield bonds have junk ratings, the bank loan ratings mix is a bit riskier, with the loan market having more “B” and “CCC” rated issues, while more than half of the Bloomberg U.S. Corporate High-Yield Index is rated “BB.”
1 The average price of the preferred index is rebased to $100, despite many of its underlying holdings having par values of $25.
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Bank loans are typically below investment-grade credit quality and may be subject to more credit risk, including the risk of nonpayment of principal or interest. Most bank loans are floating rate, with interest rates that are tied to LIBOR or another short-term reference rate, so substantial increases in interest rates may make it more difficult for issuers to service their debt and cause an increase in loan defaults. Bank loans are typically secured by collateral posted by the issuer, or guarantees of its affiliates, the value of which may decline and be insufficient to cover repayment of the loan. Many loans are relatively illiquid or are subject to restrictions on resales, have delayed settlement periods, and may be difficult to value. Bank loans are also subject to maturity extension risk and prepayment risk.
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