In their perpetual hunt for income, bond investors would be wise to take along a pair of binoculars. Reverberations from the financial crisis can still be felt four years later. Risk-averse investors continue to shun equities in favor of bonds. In the process, prices of fixed-income securities have been bid up to the point that it is difficult to find undervalued opportunities anywhere across the bond spectrum.
That said, the risk-free alternative of cash yields next to nothing. And though it isn't uncommon these days to find companies whose stock dividend yield exceeds that of their debt, an investor can't swap the entire fixed-income portion of a portfolio for equity without substantially increasing the risk profile.
What should a fixed-income investor be thinking about when analyzing valuations in the bond market?
Two common metrics used in analyzing corporate bonds are yield — the amount of interest that a bond pays as a percentage of its price — and spread — the amount of interest that a bond pays over Treasuries (also known as the risk-free rate, because the U.S. government isn't at risk of default as some companies are).
Which is more important, yield or spread? The answer depends on which segment of the bond market an investor is analyzing.
Yield tends to take primacy for investors in high-yield or junk bonds. Holders of these lower-quality bonds need to earn a high coupon interest rate to compensate for the greater risk of default.
High-yield bonds also tend to carry a higher level of liquidity risk, or the risk that it will be more difficult to find buyers for these bonds, particularly during a selling panic.
Holders of investment-grade corporate bonds may be more inclined to focus on spread. Although yields in this asset class — like those on Treasuries -— are at or near historic lows, the spread can provide not only a modicum of extra income but some cushion against the risk of capital loss if interest rates move up.
A change in the spread level also is associated with a change in the bond's value. Improving conditions for corporate credits can cause a rally in these bond prices and a “tightening” in spreads, or a decrease in the amount that they yield over Treasuries; worsening conditions can lead to a corporate sell-off and a “widening” in spreads.
When corporate bonds trade near their historically widest levels, they often are undervalued and represent a good buying opportunity. At their tightest, they are more likely to be fully valued, with little upside.
In the 25-year period through May 2007, the spread on high-grade corporates averaged 105 basis points a year. The spread is 145 basis points today.
Although that is well above the long-term average, spreads have tightened considerably since midyear, when they stood at 200 basis points.
Even if the upside on high-grade corporates is somewhat limited, however, we still view them as representing good value relative to other options — particularly Treasuries, which are the most vulnerable to price declines if interest rates rise.
CASE FOR CORPORATES
Bond analysts measure this relationship in terms of “duration”: the time over which a bond investment will be recouped through its interest rate payments. Lower-yield bonds have longer durations and therefore greater price sensitivity to interest rate changes.
Consider this example: At mid-year, the Barclay's Capital Index for five- to seven-year Treasuries had a yield of 0.94% and a duration of 5.7 years.
High-grade corporate bonds of the same maturity yielded 3.07% with a duration of 5.06 years. If interest rates rose 100 basis points, Treasuries' lower yield and longer duration would result in a total loss of 4.8%, versus a 2% loss for high-grade corporates.
If interest rates rose because of a pickup in economic activity that benefited high-grade corporates and led to spread tightening, the advantage over Treasuries would be even more pronounced.
Under this scenario, if spreads tightened by 50 basis points, a high-grade corporate would have a positive total return of 0.5%, more than offsetting the principal loss resulting from the rise in rates, while the Treasury would still have a total loss of 4.8%.
It is hard to make a case that high-grade corporates represent table-pounding value at these levels, but they are still attractive compared with the available alternatives.
Robert Persons is a fixed-income portfolio manager at MFS Investment Management.
