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Intermediate-Term Bond Managers Are Increasingly Cautious on Corporates

Valuations and a surge in BBB rated issuance are giving managers pause.

Corporate bonds were a definite bright spot for investors in 2016 and 2017 as they came off lows hit in February 2016. Investment-grade corporates in the Bloomberg Barclays U.S. Aggregate Bond Index outpaced the broad index sharply in 2016 and 2017 before suffering meaningful losses in 2018, thanks in part to the prevalence of long-maturity debt in the sector and an increase in the yield required by investors to hold investment-grade corporate debt. High-yield bonds, meanwhile, were strong performers in 2016 and 2017 and have held up relatively well for the year to date despite some weakness this fall.

On the surface, economic conditions would look to bode well for corporate bonds. Growth has been healthy and inflation contained. Few managers see risks that would lead to a near-term recession, even though the economy is in the 10th year of an expansion. Rather, they point to the fiscal boost from 2017's tax cuts, which continues to work its way through the economy, supporting already-strong earnings growth.

Despite this arguably benign economic environment, however, many intermediate-term bond managers had turned circumspect on credit risk by the end of third-quarter 2018. Some pointed to increasing risk of an economic slowdown in 2020. Many argued that the relatively tight yields that corporate bonds were paying investors in exchange for taking on additional credit risk weren't attractive. The spread on the ICE Bank of America Merrill Lynch High Yield Master II Index, which measures the additional yield paid over U.S. Treasuries for investing in junk bonds, stood at 328 basis points as of Sept. 30, near postcrisis lows last seen in mid-2014. (It widened noticeably later in the month, but spreads still look low relative to history. You can check out the latest spread data on the St. Louis Fed's data-rich site, FRED.) Meanwhile, some managers also pointed to signs of risk building in the midquality tiers of the market. A surge of BBB rated bond issuance has helped build relatively high levels of leverage on the balance sheets of corporate issuers. It's worth noting that you don't need a wave of defaults among those issuers to cause pain. It would be more than enough for the next recession to simply trigger numerous downgrades across BBB debt.

So, although most managers hadn't completely sworn off corporate credit as of earlier this fall, many of their portfolios had less credit risk than they did several years ago. For example, the typically corporate-heavy  Dodge & Cox Income (DODIX), reported a 38% allocation to corporate credit as of September 2018, including 6% in below-investment-grade debt. While that still represented an overweight relative to the fund's Aggregate Index benchmark, the fund ran with 46% in corporates, including about 10% in junk-rated names, as recently as late 2015.  Fidelity Total Bond (FTBFX) dedicated close to half of its portfolio to corporates, including a 15% allocation to high yield as of spring 2016. By September 2018, it had trimmed its corporate stake to 34%, including an 11% allocation to junk-rated debt. And though it added flexibility to hold more high-yield debt in mid-2016,  PIMCO Total Return (PTTRX) has been cautious on corporate credit for some time; as of October 2018, the fund dedicated just 24% to investment-grade credit with another 2% in high-yield credit.

Managers aren't just fleeing to cash, though; most are taking risks in other parts of their portfolios where they find valuations to be more compelling. A common theme is a preference for securitized debt. The team behind  PGIM Total Return Bond (PDBZX), for example, had trimmed corporate exposure to 32% as of October 2018, down from close to 50% in early 2016, but held about 40% of the portfolio in a mix of commercial mortgage-backed and asset-backed securities, including collateralized loan obligations. PIMCO Total Return has long favored nonagency mortgage-backed securities over larger stakes in corporate debt. Some managers have also found opportunities in emerging-markets fare. PGIM Total Return Bond and  Western Asset Core Plus Bond (WACPX) both recently held roughly 8% positions in emerging-markets debt. 

Sarah Bush has a position in the following securities mentioned above: PTTRX. Find out about Morningstar’s editorial policies.