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Eduardo Munoz | Reuters
High-grade corporate bonds had a great year in 2019, but 2020 is not likely to be as good, though there are still plenty of positives for investors looking for a fixed income alternative to stocks.
“Coming out of 2019 everything worked but some asset classes, some sectors worked better than others. If I look at investment grade corporate bonds, they’re up about 10% year-to-date,” said Kevin Mahn, CIO and president of Hennion and Walsh. That gain in the Vanguard Intermediate-Term Corporate Bond Index Fund ETF was eclipsed by much bigger annual gains in stocks, with the S&P 500 up more than 28%.
“It would be hard to imagine we could do better than we did in 2019. It was kind of perfect from a total return standpoint. It was a combination of yield levels moving lower and credit spreads narrowing,” said Jon Duensing, director of investment grade corporates at Amundi Pioneer.
Duensing said 2020 should continue to see strong demand for U.S. corporate bonds from overseas investors.
“If you look a where spreads are now relative to long term averages, they’re certainly inside of long term averages. You could point to decent economic conditions, very supportive monetary policy positions from the U.S. central bank and supportive demand from non U.S. business investors. A lot of that is priced in,” said Duensing.
Duensing said one risk for the market in 2020 is the U.S. presidential election, which could create volatility.
Yields move opposite price, so as prices rose on corporate debt, the spreads “tightened,” as yields moved closer to Treasury yields of the similar duration. That tightening accelerated into the end of the year, as investors sold Treasurys and became more confident about the economic outlook.
The ICE BofA US IG Corporate (C0A0) Index shows 14.071% of total return year-to-date and BofA Global Research expects total return of 4% to 6% for 2020.
“We like corporate bonds for next year because global banks led by the Federal Reserve have essentially extended the cycle by lowering rates and also pumping massive liquidity into the system,” said Alicia Levine, chief strategist at BNY Mellon Wealth Investment Management. “They’ve just stabilized the market, not that it wasn’t stable.”
She said corporate bonds are highly liquid and in strong demand. “Global pension funds and insurance companies cannot buy equities. they have to buy bonds and the with the global liquidity and dovish banks globally, it’s good for the bond market.”
Concern about downgrades
2019 was a year of recovery after spreads had widened and markets were dicey at the end of 2018. While stocks were plummeting, the spread between the yield on high-grade corporate debt and Treasurys, with a duration of about 7-years, was about 1.59 basis points, at the end of 2018. Last week, the spread between the high-grade corporate yield and the comparable Treasury was very close to 1.00, closer to where it was at the end of 2017.
Source: BofA Global Research
While most investors consider high-yielding junk bonds the risky part of the corporate market, investment grade debt is by no means worry free. About half of investment grade corporate bonds are rated BBB, the level just above junk bond. While some analysts have been concerned about downgrades in that tier of the corporate market, Duensing said some companies whose bonds are on the the weakest rung of investment grade have actually been doing the most to remove the concern.
“There still are a large portion of the investment grade universe that’s triple-B rated. The difference between where we were a year ago is we’ve seen more commitment from management teams to actively deleverage the balance sheet,” he said.
Telecommunications companies have been some of those working to reverse concerns about their debt. AT&T, for instance, took on about $40 billion in debt when it bought Time Warner in 2018. The company sold assets and focused on debt reduction.
In its third quarter earnings report in late October, AT&T reported that it had reduced net debt by $3.6 billion in the quarter and reduced it by $12.7 billion year-to-date.
Companies also have tried to elevate their ratings, and that could mean cheaper borrowing rates. “Over the last couple of years, we’ve seen a higher rate of companies being upgraded to investment grade than we’ve seen being downgraded to high yield,” Duensing said.
S&P Global Ratings, in a note, cites a U.S. economic slowdown, credit-risk differentiation and U.S. policy risk, such as trade, as potential negatives for corporate debt in 2020 and beyond.
Leverage reduced
They noted the BBB tier of companies could be impacted as economic growth slows, especially in more cyclical sectors, like automotive. Ford and General Motors are among the top 10 borrowers in BBB.
“Debt levels and leverage for the top 10 borrowers in this rating segment have decreased slightly this year as a result of debt repayments at AT&T and General Electric, which offset United Technologies‘ and Broadcom’s borrowing to fund acquisitions,” S&P Global analysts noted.
S&P says the weighted-average leverage declined slightly to 3 times by mid-2019 from 3.2 times at the end of last year.
“We expect credit metrics will continue to improve in 2020, with the majority of the top 10 maintaining relatively stable metrics and a few achieving more notable improvements,” S&P analysts wrote. “We expect leverage to decline at General Electric, CVS Health, and United Technologies in 2020, largely as a result of asset sales, continued debt repayment, and an all-stock merger, respectively.”
Downgrade risk and upgrade potential for the top 10 companies in the BBB category are “relatively balanced,” with two of the companies, Verizon and United Technologies, with ‘BBB+’ ratings, the highest tier of BBB, the ratings firm said.
“The rating outlook on Verizon is positive, while the rating on United Technologies is on CreditWatch with positive implications, indicating that these companies could be upgraded to the ‘A’ category in 2020. Three companies are rated ‘BBB-‘: Ford, Energy Transfer, and Broadcom. These represent 27% of the top 10 debt. The outlooks are stable,” the S&P Global analysts wrote.
Ways to play
Investors can play corporates through bond funds, or individual issues, but also through ETFs, like the Vanguard Intermediate-Term Corporate Bond ETF, VCIT or LQD, the iShares BOXX Corporte Bonds ETF , up more than 13% for the year so far.
BofA Global Research bond strategists note that one positive for the market is that there’s less issuance expected in the coming year.
“Specifically we expect a 4% decline in gross issuance to $1.137tn, a 21% decline in net supply to $399bn and accounting for other sources of internal funds including coupons, calls/tenders and net downgrades to HY the market actually throws off $72bn in 2020 after needing as much as $378bn of new cash as late as in 2017,” BofA strategists wrote. “This is a major positive and means IG will be much less reliant on inflows in 2020 than in recent history.
BofA strategist Yuri Seliger said issuance is coming off a period of high growth. “The takeaway is the market is not growing as fast,” he said. “We still have positive net supply…what this means is no new money needs to come in.”
“We think there will be a lot of positives and negatives. We are long-term neutral on the market but this kind of lack of, or decline in supply is one of the positive factors that Is offsetting some the negative factors for next year. It does matter,” Seliger said
“The yields wouldn’t have to be as high to attract demand…on net it’s a positive,” he said.
Mahn said he expects a rotation out of bonds into stocks to continue early next year, and that’s a negative for fixed income. But the drop in new corporate supply is a positive, he said.
“Any time there’s less supply and increasing demand, that’s favorable to price. Momentum right now and setniment, that’s going toward ‘risk on’ and that’s favoring equities,” Mahn said. “But if you’re looking for consistent levels of income, muni bond, investment grade corporates or even Treasurys, that’s the place to turn to.”
According to BofA, Inflows to high grade bond funds and ETFs fell to $0.97bn in the week ending Dec. 18.
“This follows four consecutive weeks of very strong inflows, including a $5.07bn inflow in the prior week. While inflows increased for high grade ETFs, flows turned negative for funds and short-term high grade. Flows also weakened for government bonds and munis, partially offset by a higher inflow to high yield. On net the inflow to all fixed income declined to $2.47bn from $6.90bn. In contrast investors bought $6.96bn of stocks after selling $6.02bn a week earlier., ” BofA strategists said in a note.
–CNBC’s Michael Bloom contributed to this story
