Senior Fixed Income Strategist, Saxo Bank Group
Summary: There is a fast deterioration in the lower-rated high-grade bond space that is becoming explosive. To limit volatility in one's portfolio is essential to pick high-quality assets and to measure duration carefully. Expect numerous downgrades as corporates gear up their balance sheet to lock in record-low interest rates.
Are you surprised by the volatility in the equity market? Please, don't!
There is plenty of reasons why volatility is high and will continue to stay that way: coronavirus, US election, trade tensions and an economic recession to mention a few.
Don't worry; it may yet not be the beginning of the end. However, a competent investor will need to listen to what the market has to say, to better plan for the future.
The system is over-leveraged. The year has not ended yet, and we already see a record high investment-grade bond issuance compared to previous years (refer to the chart below). Companies are ramping up their borrowing through the bond market to take advantage of ever low-interest rates. This aggressive new bond issuance trend doesn't play in favour of your portfolio. What is happening is that companies are gearing up their balance sheets and deteriorating their overall ability to stand economic downturns. And, if it weren't enough, we are at the beginning of an economic recession already.
It may be the right time to reconsider your equity portfolio, take profit in some of your position and look towards safer investments.
Bonds are an excellent instrument when it comes to protecting an investor from market fluctuations. When an investor buys into a bond, he locks in a specific return if held till maturity. If sold before maturity, however, there is the risk that a bond can be worth less than when one purchased it. This is the reason why, if you are switching some of your equities to enter in bonds, you want to be careful to the maturity you are choosing. If the nominal bond prices fall, you may need to hold on that bond until maturity. That's why for the majority of investors, it makes sense to look at shorter maturities and to wait out until the principal has been paid.
The good news is that at the moment there is plenty of US investment-grade corporate bonds offering an interesting pick up over the treasuries. Which one should an investor choose?
Well, it depends on what you are trying to achieve. Depending on which type of bond are you choosing, you may get a different result. As you can see from the chart below, US Aaa corporate bonds provide better returns even in circumstances of high volatility. Lower rated investment-grade bonds, on the other hand, tend to be more volatile.
There is a reason behind this trend: lower-rated investment-grade companies are the ones that in the past couple of years have been taking on more debt. Thus, they are also the most vulnerable to market shocks because they could be downgraded into junk faster than expected.
Credit erosion in the lower-rated spectrum may turn into downgrades sooner rather than later. Volatility in the market continues to be high, which means that in the long run, there will be limited funding opportunities. Corporate America will find out at its own expenses the difficulties to manage massive cost structures.
It is therefore correct to think that higher rated corporate bonds create a better buffer against volatility, but there is some bad news. They are expensive! And they will probably become more expensive as the Fed continues buying into this space (please refer to “Near-zero US Treasury yields and inflation: an explosive cocktail”).
The good news, however, is that often a downgrade is already priced in lower investment-grade bonds. This means that if the security is downgraded, the price of the bond will not fluctuate as much.
In conclusion, in the investment-grade corporate bond space, there are obvious risks. The challenge is to understand which risk can be acceptable in your overall investment strategy. Even though the lower-rated investment-grade space is vulnerable, it can still provide a nice upside if held until maturity. Better rated IG bonds, on the other hand, can be useful to limit one portfolio's volatility.
Buying a bond is very much like buying a pair of shoes. You need the right size, but you can choose from many different colours.
My right size in maturity is up 4 to 6 years, while my favourite colour is BBB/baa3, what is yours?
Please have a look at the most interesting investment-grade US corporates that we believe are available out there; it may give you some inspiration. If you are a Saxo Bank client click here, if you have a Demo account click here.
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