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U.S. corporate bonds—growing risk as the Fed tightens

Wells Fargo Investment Institute - January 2019

With the U.S. Treasury yield curve expected to remain somewhat volatile this year, Luis Alvarado, Investment Strategy Analyst, explains Wells Fargo Investment Institute’s expectations for corporate bond performance in 2019. Watch the video. 

Transcript: U.S. corporate bonds—growing risk as the Fed tightens

Title graphic: U.S. corporate bonds—growing risk as the Fed tightens

Over the last decade, the size of the corporate bond market has increased dramatically. Relatively easy financial conditions and a low interest rate environment promoted by the Federal Reserve have encouraged corporations in the investment-grade and high-yield categories to issue debt and raise capital at favorable conditions. Although the amount of debt outstanding has risen, corporate earnings have also grown, allowing the balance sheet of most companies to remain on solid footing while producing coverage levels that are strong for many issuers. 

Corporate bond issuance reached all-time highs in 2017. In 2018, however, issuance dropped close to 15% in the investment-grade space and almost 39% in high yield. This lower issuance trend is expected to continue into 2019 as financial conditions begin to tighten. Additionally, the situation could get tougher for some issuers as the wall of maturities continues to steepen this year. 

This steepening is expected to extend well into 2021, with more than $1.7 trillion of U.S. corporate debt slated to mature between now and then. 

Title graphic: Potential risk catalysts

In a liquid and low-rate environment, most issuers would have little problem refunding the maturing debt. Yet, if growth unexpectedly slows or rates spike, some issuers may begin to see their financial soundness deteriorate. The yield on the investment-grade corporate index now exceeds the average coupon, and any new debt needed to be refinanced over the next two years most likely would be issued at 100 basis points, or 1%, higher. We believe this event can signal potential headwinds ahead.

With almost 50% of U.S. investment-grade bond indices now rated BBB (one notch above junk), we believe that the greatest threat to corporate bonds may come from potential downgrades this year.

Title graphic: Investor implications 

The U.S. Treasury yield curve is expected to remain somewhat volatile in 2019, steepening at times or even inverting temporarily during periods of stress. While a meaningful yield curve inversion is a possibility, it is not our base case right now. In an environment in which the yield curve is flat but still positively sloped, excess returns from corporate bonds have been positive historically.

We expect low single-digit returns for both investment-grade and high-yield corporate bonds in 2019, but we see the potential for continued stress in spreads in the near-term, hence our neutral view on investment-grade corporate bonds and unfavorable view on high yield bonds. 

For 2019, we recommend that investors favor shorter maturities over longer maturities and look for opportunities to move up in credit quality. Shorter-term, high quality securities can potentially offer investors attractive yield opportunities that we have not seen in quite some time. We also believe this is a great time for investors to review their corporate bond holdings with an investment professional.

Risk Considerations

Investments in fixed-income securities are subject to interest rate, credit/default, liquidity, inflation and other risks.  Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price.  Credit risk is the risk that an issuer will default on payments of interest and principal.  This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk.  All fixed income investments may be worth less than their original cost upon redemption or maturity. 

Definitions

Bloomberg Barclays U.S. Corporate Bond Index includes publicly issued U.S. corporate and Yankee debentures and secured notes that meet specified maturity, liquidity, and quality requirements.

Bloomberg Barclays U.S. Corporate High Yield Index covers the universe of fixed-rate, noninvestment-grade debt.

Bond rating firms, such as Standard & Poor's, use different designations consisting of upper- and lower-case letters 'A' and 'B' to identify a bond's credit quality rating. 'AAA' and 'AA' (high credit quality) and 'A' and 'BBB' (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ('BB', 'B', 'CCC', etc.) are considered low credit quality, and are commonly referred to as "junk bonds".

General Disclosures

The opinions expressed reflect the judgment of the speaker as of the recording date and are subject to change without notice. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results. Additional information is available upon request.

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The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor.  This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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