How to cope with rock bottom corporate bond yields

The hunt for income just got a lot harder. The yield on US investment grade (IG) corporate debt recently fell below 2% for the first time ever, as expectations seep in of a persistently low interest rate and inflationary environment.

Against this backdrop, investors face a tough road ahead. They can settle for paltry yields or ride up the risk spectrum to make up for the shortfall in returns.

However, those that choose the latter should tread carefully. You shouldn’t lend to a business just because it pays a high return. As we have written before, such an approach is likely to suffer the most during economic downturns.

Selective risk-taking and rigorous analysis of company fundamentals are essential to generating a satisfactory income without compromising on quality.

Why have yields tumbled? 

The yield on a corporate bond is made up of two components – a base interest rate and a credit spread. The interest rate is equal to the yield on a government bond with a similar maturity, which is considered to be risk-free. The credit spread reflects the extra compensation investors receive for bearing default risk, which is inversely related to the credit worthiness of the corporate. 

In March, the US Federal Reserve launched a massive stimulus programme by purchasing large swaths of government and corporate debt. This provided much-needed liquidity and support to the market amidst the turmoil generating by the coronavirus. In response, interest rates cascaded to record lows, which dragged down yields on corporate bonds. Meanwhile, although credit spreads have come down as well, they still remain above pre-crisis levels.  

What effect have lower yields had on bond characteristics?

One consequence of lower yields is increasing duration. Duration is a measure of a bond’s price sensitivity towards interest rate movements. For example, before 2008, a 0.5% rise in yields would have resulted in corporate bond prices falling by 3.1%. Yet today, it would result in a loss of 4.2%. When coupled with the fact that yields are much lower to start with, it would take very little movement in bond yields to leave investors nursing losses. 

But don’t worry, there’s hope

Investors can reduce their interest rate sensitivity by shortening the duration of their portfolio. The opportunity cost of this trade would be the forgone income from investing in higher-yielding, long duration bonds.

However, it’s important to remind investors that not all corporate bonds lie neatly along a curve. In fact, as the chart below illustrates, there is a broad spectrum of income opportunities available for a given level of duration, or alternatively a fixed income available for a lower duration.

For example, investors can earn a yield of 2% with a duration of 8.5 years at the US IG index level (the yellow diamond). But there are many other bonds available that achieve the same level of yield with less interest rate sensitivity.

Some of this yield pick-up will reflect the market’s dimmer view of these companies’ prospects or because those companies have a lower credit rating, but not always. Bonds with relatively lower liquidity or a smaller issue size can also make a bond less attractive to some investors and result in a higher yield without a commensurate increase in credit risk. When we repeat the analysis for individual credit ratings, there remains significant dispersion.

Fundamental research is key to identifying mispriced bonds and avoiding those that turn out to be cheap for good reason. A selective approach, within a highly diversified portfolio, can take advantage of the full range of income options and potentially generate a more satisfactory outcome for investors.