Taking Risks in Corporate Bonds Paying Diminished Rewards

By Katherine Chiglinsky and Matt Robinson

It’s getting harder for bond investors to boost their returns by taking more risk in corporate debt.
With just a month to go, company bonds from the riskiest to the most-creditworthy worldwide have gained 1.1 percent more than government securities in 2014, the least in three years, according to the Bank of America Merrill Lynch Global Corporate & High Yield Index. After booking average excess returns of 6.5 percent in the five years following the financial crisis, investors are now getting paid the slimmest risk premiums in eight years for holding corporate debt.
The eroding gains are leaving investors in a precarious position heading into a year when the Federal Reserve is forecast to raise interest rates for the
first time since 2006. That’s prompting buyers to pull back from the riskier corners of the market, where companies have had little trouble getting funding amid six years of unprecedented Fed stimulus.
“If you’re buying a bond fund and you expect the prices to rise and that’s your primary reason for buying, you’re probably not going to be happy over the next few years,” said Thomas Byrne, a director of fixed income at Wealth Strategies and Management LLC in Stroudsburg, Pennsylvania, which oversees $160 million in assets.

Pulling Back

Corporate bonds are capping the third straight month of declines relative to government debt as the extra yield investors demand to own them widens from the almost seven-year low of 1.56 percentage points reached in June, the Bank of America Merrill Lynch index data show. At 1.93 percentage points, spreads are about where they were a year ago and haven’t exceeded 2 percentage points since then. That’s below a 10-year average of 2.3 percentage points.
Investors have pulled back from riskier assets, particularly in the market for speculative-grade debt, amid concern a combination of slowing growth and the anticipated interest rate increase next year will lead to a pickup in corporate defaults. Companies have had little problem meeting their obligations as they refinanced debt and pushed out maturities by issuing $2.27 trillion of junk bonds globally since the end of the credit crisis in 2009.
“There’s been a return of volatility to the marketplace,” Anthony Perrotta, director of fixed-income research at advisory firm The Tabb Group LLC, said. “There are signs Japan slipped back into recession, Europe continues to be in recession and China’s growth is slowing.”

Credit Deteriorates

Standard & Poor’s is forecasting U.S. company credit quality will decline and more companies may see cuts than increases in their ratings, the debt grader said in a Nov. 25 report. Speculative-grade default rates reached 2.3 percent in October, up from 2.2 percent the month before, Moody’s Investors Service said in a Nov. 12 report.
Junk bonds worldwide lost 0.86 percent relative to government debt in November, only the third monthly decline this year. That trimmed excess returns to 0.9 percent for the year. Investment-grade securities gained 1.14 percent.
This month’s declines were led by debt of energy companies as oil prices dropped to a four-year low. Those securities lost 1.44 percent relative to government debt, according to the index data.

Sovereign Gains

“Mostly it’s the energy space. It’s provided that recent weakness,” said Matthew Duch, a money manager at Bethesda, Maryland-based Calvert Investments Inc., whose firm oversees about $13 billion.
Yields on the riskiest U.S. company bonds, those rated CCC or lower by S&P, climbed to 10.64 percent Nov. 27, Bank of America Merrill Lynch index data show.
Corporate bonds were weakest in the U.S., with dollar-denominated debt losing 0.6 percent relative to Treasuries. In Europe, the securities had gains of 0.11 percent over government bonds, while in Asia, returns for the month were minimal at 0.02 percent.
As investors retreated to the relative safety of government debt, a Bank of America index of sovereign debt gained 1 percent in November, extending the year’s gains to 7.4 percent.
“I think this is a correction to a corporate rally that’s been over the past three years,” Scott Carmack, a money manager at Portland, Oregon-based Leader Capital Corp. which oversees $1.5 billion in fixed-income assets, said in a telephone interview Nov. 25.