Market Conditions Support Corporate Bonds

PTR2-market_commentary_base_May 24 (Compass).jpgBy Julianne Bass, CFA

Senior Portfolio Manager of Fixed Income


Credit spreads for corporate bonds — the yield difference between corporates and Treasuries of the same maturity — are close to the tightest they’ve been in the past two decades.


Ultra-tight spreads are a cautionary sign that credit may be overvalued, as investors receive relatively little compensation for the greater risk of owning corporate bonds compared to owning government debt. In early 2016, the investment-grade (IG) spread was 2.2% above Treasuries; now, it’s inside 1.2%. High-yield (HY) spreads have narrowed from 8.6% to less than 4% over the same period.


Julianne Bass, Senior Portfolio Manager of Fixed Income Investments.jpgWhile credit prices look to be on the lofty side, there are several key reasons why we think they may be resilient for at least the next few quarters, and maybe even longer.


 The first reason is improving U.S. corporate fundamentals, which stand to reduce the risk that companies might default on their debt.


Revenue and earnings growth for the Standard & Poor’s 500 came in much higher than expected in the first three months of 2017. In fact, it was the best quarter in more than five years, and the current outlook for the rest of the year is good. Companies are also spending more on building their businesses. This is not just a U.S. phenomenon; fundamentals are also improving in several global markets.


The U.S. default rate for both IG and HY credits has been below average for some time now, even with debt issuance up sharply due to historically low interest rates. The consensus forecast calls for the default rate to edge even lower, though some companies in some industries (such as retail and energy) may be vulnerable to moving in the other direction.


A second reason is ebbing expectations for U.S. economic growth as Trump agenda dreams — tax reform, regulatory cutbacks and a huge infrastructure program — run up against Congressional reality. This could result in less inflation pressure and thus less need for the Federal Reserve to be aggressive in raising short-term interest rates.




We agree with the consensus that a June hike is pretty much locked in. But, assuming inflation remains in check, the Fed may or may not opt to act again in 2017. And it’s worth a reminder that Fed rate policy raises only the short end of the yield curve. Yields at the longer end of the curve are down year to date, reflecting a market view that GDP growth projections may be too optimistic.


Such meager fixed-income yields have created strong and persistent demand for securities generating higher income than Treasuries or other government debt. This is the third reason we believe IG and HY prices may hold up. The U.S. credit market is attracting inflows not only from domestic buyers, but also from yield-starved investors overseas whose local interest rates are even lower.


We build and manage our portfolios bond by bond, with our buying decisions being based on a rigorous analysis of each individual credit. These days we are finding selective opportunities in some beaten-up sectors; these include European banks, energy and mining. Of interest on the HY side are bonds issued by retailers with a compelling reason to maintain a brick-and-mortar presence.  


Our general outlook presumes that market conditions more or less stick to their current course — no inflation spike that might animate the Fed and no recession that could undercut corporate earnings expectations, raise default risk and create other uncertainties. Should these macro conditions change, we would have to reassess our views.  





As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are suited for you based upon your individual goals, objectives, risk tolerance and time horizon.


Investing in securities products involves risk, including possible loss of principal.


This material is provided for informational purposes only by USAA Asset Management Company (AMCO) and/or USAA Investment Management Company (IMCO), both registered investment advisors. The material is not investment advice and is not a recommendation, an offer, or a solicitation of an offer, to buy or sell any security, strategy or investment product. The views and opinions expressed in the material solely reflect the judgment of the authors, but not necessarily those of AMCO, IMCO or any affiliates as of the date provided and are subject to change at any time. All information and data presented herein has been obtained from sources believed to be reliable and is believed to be accurate as of the time presented, but AMCO/IMCO does not guarantee its accuracy. The information presented should not be regarded as a complete analysis of the subjects discussed. Any past results provided do not predict or indicate future performance, which may be negative. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of AMCO/IMCO and USAA.


Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.


The fixed income securities are subject to price volatility and a number of risks, including interest rate risk. Interest rates and bond prices move in opposite directions so that as interest rates rise, bond prices usually fall and vice versa. Interest rates are currently at historically low levels. Fixed income securities also carry other risks, such as inflation risk, liquidity risk, call risk, and credit and default risks. Lower-quality fixed income securities involve greater risk of default or price changes. Securities of non-U.S. issuers generally involve greater risks than U.S. investments and can decline significantly in response to adverse issuer, political, regulatory, market and economic risks. Fixed income securities sold or redeemed prior to maturity may be subject to loss.


Investments in foreign securities are subject to additional and more diverse risks, including but not limited to currency fluctuations, market illiquidity, and political and economic instability. Foreign investing may result in more rapid and extreme changes in value than investments made exclusively in the securities of U.S. companies. There may be less publicly available information relating to foreign companies than those in the U.S. Foreign securities may also be subject to foreign taxes. Investments made in emerging market countries may be particularly volatile. Economies of emerging market countries are generally less diverse and mature than more developed countries and may have less stable political systems.


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