Not a Time to Reach for Yield; Focus on Investment Grade Corporate Debt
By Doug Drabik
Many investors practice prudent asset allocation utilizing different asset classes for very different purposes. Growth assets may carry greater risks but they typically allow portfolios the greatest opportunity to increase in value. Fixed income assets may afford investors better protection against loss with predictable cash flows and income streams. Combined, the two asset classes can cultivate a proficient portfolio. However, the two asset classes can sometimes be confused when evaluating and reading headline expectations.
When interest rates go up, there is a danger that corporate borrowing costs go up. As corporate expenses rise, it is presumed that eventually higher prices will offset costs and in time drive the potential for higher inflation. With the Fed possibly on the verge of another rate hike, the doubters begin to recall the 2008 corporate meltdown. There are many considerations here. Many of our readers own investment grade corporate bonds and/or those bonds with credit ratings in the higher range of investment grade. The higher credit ratings are intended to reflect stronger balance sheets which are positioned to grow while absorbing market fluctuations. The 2008 meltdown hit some poorly rated credits. Companies with weaker credits found it difficult to roll debt into rising or higher interest rates. For some, availability of short term funding was limited, resulting in a lack of liquidity. The Fed Funds upper band rate in January 2008 was 4.25%, significantly higher than the current 1.75%.
Moody’s reports that the global speculative-grade default rate is currently quite low at 3% but that low interest rates and available credit have provided a path for low quality new issuers, pushing corporate leverage to historic highs. S&P reports a similar warning that in 2007, corporations with debt/earnings above 5x was ~32% compared with ~37% today. With marginal improved yields in high yield corporates, there is a strong argument for investors to focus within the investment grade space.
This graph by the Federal Reserve Bank of St. Louis (FRED) uses debt as the numerator and capital and reserves as the denominator. It is a measure of corporate leverage the extent to which activities are financed out of own funds. The shaded area is a period of recession.
Other factors to consider:
Staying within the investment grade space and a modest duration range of 3-9, investors can capture close to 4.00% yields with a laddered strategy. The strategy allows an investor to continually roll maturing assets into the latest interest rate environment. Being mindful of asset class allocation and credit is imperative given the current domestic and global environment.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.