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Are Corporate Bond Investors Getting Paid Enough?

Jeremy Glaser
Dave Sekera, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

I'm here today with Dave Sekera. He is Morningstar's corporate bond strategist. We'll look at the state of the corporate bond market and see if investors are being adequately rewarded there.

Dave, thanks for joining me.

Dave Sekera: Always good to talk to you, Jeremy.

Glaser: So that really is the core question here: For investors who are looking at corporate investment-grade securities, are they being adequately compensated for taking on that credit risk in investing with these companies?

Sekera: In today's market, I would actually answer that as both a yes and a no answer. Unfortunately, I kind feel like an economist: "on this hand, and on that hand." But when you take a look at the corporate bond market from just a pure credit spread basis, the added spread that you would get over Treasury bonds that compensates you for that credit risk or potential of default risk, I do think you're being adequately compensated. Now, at this point, credit spreads have tightened up a pretty good amount over the past couple years. We were overweight in our recommendations for corporate bonds, although we did change that last fall to more of a market weight, more of a neutral-type opinion as we saw credit spreads tighten in. I think maybe they've tightened another 10 basis points since then, but really we've been in a pretty tight trading range since last fall.

Now as far as the probability of default, corporations are looking pretty good. Balance sheets are still in pretty good shape at this point. But just taking a look at the earnings, the top line still is very sluggish. Earnings are doing OK; free cash flow is there. But we're not seeing the rapid improvement that we had been seeing in corporate credit metrics since the end of the credit crisis up until probably the middle of last year.

Now having said that, for your all-in interest rates in corporate bonds right now, if you take a look at the Morningstar Corporate Bond Index, because the yield on Treasury bonds has come down so much, I believe the average yield on our corporate bonds is about 2.7%. So on an all-in basis, no, you're really not getting compensated the full amount, because I think interest rates themselves have gotten so low that you're really not being compensated for inflation risk going forward.

Glaser: So let's talk a little bit about this low rates, and when they could start rising again. That's obviously, a big concern for fixed income investors. What are your expectations for how fast rates could rise or even when they could start going up?

Sekera: Let me preface to start off with, we really aren't in the game of trying to forecast interest rates. We really are bottom-up fundamental credit research analysts.

Having said that, on average, the 10-year Treasury bond, for example, usually trades about 200 basis points over the rate of inflation. So the rate of inflation right now is about 1.8%, and we're looking at the 10-year Treasury bond in that same range, I think it's 1.75% today. So essentially you have negative real yields in Treasury bonds all the way out through the 10-year. And, of course, that's really just because the Federal Reserve is out there with their asset purchase program, purchasing $85 billion worth of mortgage-backeds and Treasuries every single month.

Now, when they do start to taper that off, when we get to the point where they think job growth and where economic growth is at the point where they can start reducing that, I do think the Federal Reserve might be surprised just how quickly interest rates could start rising.

So, for example, just to get back to the average of that more normalized rate, that means a 10-year Treasury bond could back off 200 basis points, 2%, which would take us to a 3.8% Treasury rate, which, of course, is going to be a big shock to those corporate bond investors that are in long-dated bonds. Depending on how quickly that backs off, you could see, with an 8-year duration on a 10-year bond, up to 16% loss in the principal value of those bonds.

Glaser: So that interest rate risk is pretty apparent. What other risks should corporate bond investors have on their minds right now?

Sekera: Well, from a general market, more of a systemic risk viewpoint, we're always concerned about what's going on in Europe. We don't think that the problems there have really been solved. Taking a look at the peripheral nation, such as Italy and Spain, their GDP is still continuing to decline. I think this quarter, if they have negative GDP growth, it'd be the fifth or sixth quarter in a row that they've had losses in their economies. As such, their loan losses in the banks are still continuing to rise. So we don't think that they've really turned the corner from a risk standpoint just yet.

Now, things have gotten better; confidence had returned to the region after Chairman Draghi of the ECB went out there and told the market he was going to do whatever it takes to preserve the euro. But we do still think that taking a look at some of these issues, like Cyprus, where we now realize that bondholders are going to have to take losses if we need bail-ins of other banks. That could start causing interest rates, or really the corporate credit spreads on those bank bonds, to start backing off as people realize that that risk is there.

Glaser: Do you have any worries about emerging-market growth at all?

Sekera: On the emerging-market side, it's been holding in fairly well. We have seen some declines in the growth rates in the emerging markets, specifically in China. China has really bolstered its economy for years and years now based on infrastructure growth, and at some point China does need to make that transition from really being all based on infrastructure growth into more of a consumer-driven, or at least a more balanced economy with consumer spending. Historically, if you've ever really looked when that transition has occurred with other high-growth emerging-market nations, there's always been a pretty large economic disruption when that happens. I'm not saying that's going to happen necessarily in the near term, but that is another more systemic risk out there that we could see. And if China's economy does take some sort of hard landing, that of course really would affect the global economics as well.

Glaser: What about issues out of Washington? We've seen the fiscal cliff, debt ceiling debate, that's really roiled the markets at times. Is that still something that is a big concern for investors right now?

Sekera: So for our own economy, I know Robert Johnson, our director of economic analysis, is still looking for 2% to 2.5% real GDP growth this year. So I think the biggest economic concerns we're going to have would be more what I call self-inflicted wounds. So probably the two areas would be monetary policy and fiscal policy.

So on the monetary side, if the Fed does start to taper back its purchases either too soon or if it tapers them back too quickly, I do think that we could see some disruption in the asset markets--the bond market, the equity market, the housing market, and so forth. And if those markets really got hurt too fast, then we could see high-end consumers, who have really been sustaining consumer spending for us the past couple of years, pull in the reins, which could have a damaging impact.

On the fiscal side, in Washington, we're still having the consistent battles between austerity, increasing taxes, and so forth. So as the politicians are really hammering that out, everyone realizes, or should realize anyway, that we really do need some sort of long-term solution, that we can't continue to keep running at the same kind of deficits that we are now. And in order to do that, there is going to have to be changes that get made. So I think as they go through, and try and figure out what the budget's look like going forward, if they swing the pendulum too far in either direction, towards austerity or towards increasing taxes, that also could be some self-inflicted wounds that could cause economic disruption here at home.

Glaser: Dave, thank you so much for your thoughts today.

Sekera: You're welcome.

Glaser: For Morningstar, I'm Jeremy Glaser.