Triangulating Risk in the Corporate Bond Market Today

Note: This video is part of Morningstar.com's November 2014 Risk Management Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Dave Sekera; he's our corporate bond strategist. We'll look at risk in the corporate bond market and what investors can expect going forward. Dave, thanks for joining me today.

Dave Sekera: Happy to be here.

Glaser: Let's first talk about the right way to think about risk in the corporate bond market. When people think about bonds, they think maybe of interest-rate risk or duration risk. What are the things that you should keep in mind maybe when evaluating a corporate bond investment?

Sekera: Well, there are really two parts in corporate bonds that I think investors should really focus on when they are thinking about it in their own portfolios. As you mentioned, first is the interest-rate risk. Just as underlying Treasury bonds are moving around, interest rates are moving around, that can impact the value of what the funds will be and the value of the individual bonds. So, when interest rates are rising and you're stuck in a low-coupon bond, the value of those bonds will decrease--and vice versa. If interest rates in Treasuries are going down and you've got a good coupon bond, the value of that bond will go up.

But in addition to the interest-rate risk in corporate bonds, we also have the corporate credit risk. And, really, what you're doing is you're getting paid a spread, or a credit spread, over what the underlying Treasury bond is. And what that does is that compensates the investor for the added risk of potential corporate default at some point in the future. So, the riskier an underlying corporation is, the more that individual will get paid for that corporate credit risk.

Glaser: Let's start by looking at corporate credit spreads, then. What do they look like today compared to historical levels?

Sekera: Right now, when we look at corporate bonds, we have two different indices that we use. The first is the Morningstar Corporate Bond Index. That's really an investment-grade bond index. So, that's for those bonds that are rated BBB minus and higher. And then what we use on the high-yield side--and those are the bonds that are also known as junk bonds. They are rated BB plus and lower. So, what we use there to measure that market is the spread within the Bank of America Merrill Lynch High Yield Master II Index.

So, when we look at spreads right now, I really think that spreads are probably what I consider to be at the tight end of a fairly valued range. So, what we've seen recently is that, in the investment-grade market, the current spread in our index is 131 basis points. On average, if you look at since the beginning of the 2000s, it's been about 158 basis points. So, we are a little bit tighter than average right now, but really not that much tighter. On the high-yield side, that average is actually about 580 basis points. I think the Merrill index right now is about 450 basis points.

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Glaser: What's driving those spreads to that tighter level? Is it that corporate credit quality is better, and so people just don't need to be compensated as much? Is it a search for yield. Why are these so low?

Sekera: It's a little bit of both. We did have the Federal Reserve's quantitative-easing program, which just recently ended. That did help the corporate credit market earlier this year as the Fed was out buying Treasury bonds and taking that supply out of the market. A lot of those investors were then reinvesting those proceeds into the corporate bond market. And because yields have been so low, they have been looking for that added yield, which has definitely benefitted that market as well.

But as you mentioned, it's also that the corporate credit risk has generally been improving over the past couple of years, especially in the financial, or the banking, sector. The banks, especially, really don't suffer as much idiosyncratic risk as what we've seen in the industrial sector, just because the Federal Reserve has really kept a very tight rein on the capital structure of the banks. So, as they haven't been able to pay out as much in dividends, as they have been retaining a lot of their earnings and capital, their corporate credit risk has improved. And we've seen spreads within the banking sector, specifically, tightened further and faster over the past couple of years as compared to the industrials.

Glaser: Do you expect corporate credit quality to remain high or are there defaults on the horizon? Do you expect management teams to be more aggressive or are firms using cash flow to pay down debt?

Sekera: It's a little bit of all of the above. It just kind of depends on the corporation and the sector that we're looking at. Generally speaking, we're expecting, for 2015, GDP growth of 2% to 2.5%, which is really a good area for the corporate bond market in that what we expect is that companies will still be improving their cash flow, they'll be growing their top line. Assuming margins are kind of in the same area where we are right now, then the cash flows improve and that should improve corporate credit risk, keep default rates in the high-yield market probably in that low-single-digit area. As such, we expect that corporate credit spreads will probably grind tighter going into the end of this year and probably into the beginning of next year.

Glaser: Let's take a look at interest-rate risk, then. Many people, including us, predicted that interest rates would increase in 2014. That has obviously not been the case. Do we have an outlook for rates? And if so, what kind of impact would rising rates have on the corporate bond market?

Sekera: In the corporate bond market, I tend to be a little bit more agnostic as far as interest-rate risk. We really just stick to looking at individual bond risk and that credit-spread risk being fundamental to bottom-up investors. But when we take a look at the Treasury bond market, we do know that the Fed has exited. And so, really, what I do is I look to see what were the normal historical metrics that Treasury rates used to trade as compared to current inflation, inflation expectations, and the shape of the yield curve.

So, while I can't say we're going to be at 3% on the 10-year Treasury at this time next year, I really do expect that Treasury rates over the medium to long term really should start rising as we get to more normalized metrics as compared to where bonds used to trade before the Federal Reserve was so involved in the market with their quantitative-easing programs.

Glaser: What kinds of returns, then, do you think investors can expect over that medium term in high-yield bonds and also the investment-grade bonds?

Sekera: I'll start off with the investment-grade bond market. Investment-grade bonds, because they do have a lower spread, are a lot more sensitive to underlying interest-rate movements in the Treasury bond market. Now, if the Treasury bond market does start going up and we see yields rising next year, that's going to offset a lot of the current carry that you're getting. So, right now, I think the current yield on the Morningstar Corporate Bond Index is just slightly over 3%.

So, if we see interest rates start to rise, the decrease in the value of the bonds will eat into your total return over the course of next year. However, I do think that as corporate credit spreads do start to grind a little bit tighter over the course of the beginning of next year, that will help offset some of that loss from Treasury rates. So, really, I'm thinking we'll probably break even or struggle to get a little bit over a couple of percent return for next year.

The high-yield market probably should fare better than the investment-grade bond market next year. High-yield bonds do have a little bit shorter duration, a little bit higher coupon, and so they are less sensitive to interest-rate movements than the investment-grade bond market. Plus, because you're getting that added carry with those larger credit spreads, which are protecting you from default risk, I do think that you'll see better returns in high-yield next year as opposed to what we've seen this year.

Glaser: We have seen some volatility over the last couple of weeks. What do you think is driving this? And why do you expect those spreads to continue to get tighter potentially?

Sekera: We actually really saw two waves of volatility over the course of this summer. If you take a look at corporate credit spreads, they hit their tightest levels this summer in June. And then in June, we had a lot of economic metrics that were coming out. We had some growth-slowdown fears globally. And really, we ended up seeing corporate bond spreads start to widen out, saw them start to widen out in the high-yield space. And as they started to widen out, then we saw a lot of fund flows, especially in the high-yield space, turn negative as a lot of investors were pulling money out of that market.

We got a little bit of a snapback in the fall, and then things normalized for a little bit. But then, again, we started running into some more fears. We had some concerns with the Ebola headlines--which, while we didn't think that was necessarily going to impact the market over the long term, it certainly made a lot of investors very nervous. Again, we started seeing some more slowdown coming out of Asia--China, specifically, as their GDP continues to slow down.

Europe has been struggling with their economy as well. So, a lot of these growth fears, again, really started to cause more concern, especially in the high-yield market. And then we saw that next wave of negative fund flows and that next wave of credit-spread widening in October. We've really seen a lot of volatility in those week-to-week flows. We had one of the largest outflows this fall; that was followed by a bit of a snapback as flows came back in, as people saw that bonds were getting cheaper. And then they went the other way, and they flowed back out. And then, even last week, we saw $3.5 billion come into the high-yield market, which is one of the single largest weeks that we've had of fund inflows for the past couple of years. So, it has really been an interesting time to look at the dynamics of the fund flows versus those corporate credit spreads.

Now, in addition to that, we've also seen a huge amount of new issuance in both investment-grade and in the high-yield market over the past two weeks. In fact, the amount of new issuance just of those companies that we cover in the research side here at Morningstar, that amount of new issuance in those two weeks has been greater than any other three-week period, going back to when Verizon did its big megadeal a couple of years ago.

So, really, we've had a lot of new issuance that the markets have had to digest, and that has also helped keep corporate spreads on the wider side. As we start getting up toward the holidays, the new-issue window will start to close, and so we'll have less volume coming in in the new-issue market. Then, I expect to start seeing that technical come out of the market. And corporate credit spreads both for investment-grade and high-yield should probably start tightening in the latter half of November, going into December. And then, as long as the economy is still holding next year, we should see those tightening in the first part of next year as well.

Glaser: Dave, thanks for the update on corporate credit today.

Sekera: You're quite welcome.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.