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Today’s fixed income landscape is anything but normal. With U.S. short-term interest rates hovering near zero (Figure 1) and long-bond rates near multi-decade lows, income generation has become more difficult to achieve. Additionally today’s low yields offer investors in long-bonds relatively little compensation for the duration risk that they are taking on. Given these overall dynamics, we continue to advocate an underweight position to the fixed income space as a whole. However, that does not mean fixed income investment opportunities do not exist. On the contrary, we see attractive fundamentals in certain areas of the fixed income market, most notably in the corporate bond sector.

U.S. Treasury Bonds, Unlikely to Repeat as Champions in 2012

The fixed income markets in the U.S. are vast, consisting of several different sectors. Treasuries are the first thing to come to mind when most people think of fixed income, and they make up a very substantial portion of the main fixed income indices such as the Barclays Capital U.S. Aggregate Bond Index and the BAML U.S. Broad Market Index (Figure 2 shows the composition of BAML U.S. Broad Market). In last year’s risk averse environment, Treasuries significantly outperformed as investors flocked to safety. In fact, Treasuries with longer maturities earned massive double-digit returns, with the Bank of America Merrill Lynch U.S. Treasuries 15+ Index gaining 31.72% for the year in 2011. Such noteworthy results are certainly attention-grabbing, but the chances of similar returns for 2012 are low (Figure 3).

Indeed, despite this recent strong performance, a closer look at the fundamentals in the Treasury market exposes multiple potential concerns. With yields already near historic lows, there is arguably more risk to the upside for yields/interest rates over the long run. Given the inverse relationship between bond prices and yields, that means Treasury prices are likely to fall over time. Furthermore, the ongoing increase in the size of the U.S. deficit creates potential pressure for the Treasury market down the road. The recent U.S. credit rating downgrade reflects concern about the U.S. deficit situation, but investors shrugged off that initial warning and instead retreated into Treasuries seeking refuge from the EU sovereign debt crisis. Overall, while Treasuries may have benefited from the fear-driven environment in 2011, from a fundamental perspective Treasuries have more headwinds than tailwinds today.

Why Corporate Bonds?

Meanwhile, the picture looks much better for the corporate bond market. Corporate America is relatively healthy today. While the overall economy remains mired in a slow growth environment, large companies in general have been earning strong profits with healthy profit margins. Many of these companies are taking advantage of low interest rates to refinance or access the bond market for fresh capital. These conditions, along with the generally risk adverse market environment, are creating attractive investment opportunities in the corporate bond market.

While investment grade bonds and high yield (i.e., “junk”) bonds both fall under the corporate bond market umbrella and share many similar qualities, it is helpful to provide further context. The main difference is that high yield issuers are rated “below investment grade” as their business profile lacks the size, strength, or diversification to achieve an investment grade rating or their debt level/ credit ratios do not meet the ratings criteria to be deemed investment grade (i.e., if a company is more levered). Due to their weaker business profiles or higher debt burdens, high yield issuers have historically defaulted at a significantly higher rate than their investment grade peers. Additionally, the high yield sector is not included in most broad fixed income indices (i.e., Barclays Capital U.S. Aggregate Bond Index), meaning owning high yield is often an out-of-benchmark allocation decision. In return for the added risk, the high yield sector typically offers some of the highest potential rewards in the fixed income market. High yield bonds have historically generated equity-like returns with lower volatility.

High yield and investment grade corporate bonds historically have both produced attractive returns for several years following a recession as defaults recede and credit spreads tighten (i.e., the difference between corporate bond yields and Treasury yields narrows). Corporate bond returns, as compared to Treasuries, are typically strong during periods of recovery as Treasury yields begin to rise in response to better economic growth and credit spreads tighten.

For the most part, this was the case in the two years following the 2008 credit crisis. However, corporate bond returns were more moderate on an absolute basis in 2011. Corporate bonds (and particularly high yield bonds) generally underperformed the broader fixed income market last year (Figure 4), a result of the strong rally in Treasuries and a widening of credit spreads as investors piled into Treasuries and shunned what they perceived to be riskier assets.

Last year’s fixed income returns reflected the fear-driven market environment. However, we believe the fundamentals continue to favor spread sectors such as corporate bonds over Treasuries. In particular, we see four main reasons that high yield and investment grade corporate bonds present compelling investment opportunities in today’s environment:

1. Attractive Spreads: The spread between corporate bond yields and Treasury yields remains attractive, although below the peak levels typically seen during times of crisis (Figure 5). In general, a wide credit spread represents substantial reward potential and ability to outperform treasuries due to the incremental income investors receive as well as the potential for capital appreciation when credit spreads compress. Additionally, there has historically been a negative correlation between credit spreads and movements in treasury yields, meaning that corporate bonds may be less sensitive to interest rate fluctuations, especially high yield bonds where the movement in credit spreads often overpowers the move in the underlying treasury rates.

The credit spread compensates investors for the credit risk—probability of default and loss given default—of the underlying issuer. Additionally, investors of corporate bonds require a risk premium, which compensates them for the risk/volatility of the investment over that of a “risk free” instrument such as Treasuries. For the high yield market, current spreads are around 586 basis points (BAML U.S. High Yield, Cash Pay Index as of 03/05/2012) and investment grade spreads are at 200 basis points (BAML U.S. Corporate Master as of 03/05/2012), which is pricing in a significantly higher level of defaults and/or a higher risk premium than we believe is necessary given current economic conditions. Thus, we believe spreads are currently at attractive levels.

2. Moderate Default Rates: Speaking of default rates, defaults are currently near trough levels. After the spike in defaults that occurred as a result of the 2008 credit crisis, the default rate has dropped down near long-term lows (Figures 6 and 7). While the ideal time to buy corporate bonds—particularly high yield bonds—is when defaults are peaking, we do not expect a meaningful increase in defaults in the near future. There are two key reasons why we see moderate default rates over the next few years. (1) Following the pain from the recent credit crisis, the quality of the remaining corporate bond issuers has improved, as many of the weaker companies defaulted during the last recession. Looking at the high yield market in particular, about 16% of the market is currently rated CCC or lower (i.e., the lowest quality credit rating). That compares to over 30% of the market at the peak in 2008. The market has a higher quality tilt today. (2) Many companies benefit from an ample runway, meaning they have pushed out their near term refinancing needs, as companies used the high level of demand during the 2009–2011 period to refinance their capital structures and extend maturity profiles, leaving them in good shape in the current environment.

3. Supportive Economic Indicators: On balance, economic indicators remain supportive for the corporate bond market. Recent economic data has shown positive momentum for the U.S., but overall the economy remains in a slow growth environment. Below we have listed some of the main indicators we monitor.

4. Market Internals: Finally, market internals remain supportive for corporate bonds. Supply slowed noticeably in the latter half of 2011 due to the overall market sell-off and general risk aversion. Within the high yield market, the end of last year was also characterized by higher quality supply than is typical when the market re-opens after a period of weaker demand. Due to strong investor demand, we have seen a higher level of supply at the start of 2012 with smaller new issue concessions and some slippage in deal quality; however, there has been a limited amount of the lower quality, poorer structured supply that is typically seen at market tops. As for demand, investors continue to seek yield. This appetite for income is likely to contribute to strong demand for some time.

Potential Risks

As with any investments, the corporate bond market is not without risks. Indeed, there are several distinct risks we continue to monitor in the current slow growth environment. If economic growth were to slow considerably or fall into a recession, we would expect a higher level of defaults and credit spreads to move significantly wider, leading to capital losses. Once again, our outlook for the U.S. economy is for slow growth, and we believe if the economy were to dip into a recession, the outcome would be milder than the intense crisis we experienced in 2008. A banking or financial crisis, potentially driven by sovereign related issues, would negatively impact the corporate bond market. Lastly, the potential for shorter economic cycles represents another potential risk for the corporate bond market. Shorter economic cycles mean choppier growth and more volatility, arguing for higher credit spreads.

On the other hand, if the U.S. went through a period of higher than expected growth, that could be beneficial to the corporate bond sector, particularly relative to Treasuries. Treasury yields would likely rise on higher growth expectations, and any rumblings of a pickup in inflation would likely hurt longer-dated Treasuries. Meanwhile, growth is good for corporate profitability and corporate bond spreads, and they would likely outperform Treasuries in a higher growth environment.

Conclusion

Given the overall fixed income landscape, we believe the corporate bond market is an area that offers an attractive risk/reward balance. In particular, we believe high yield and investment grade corporate bonds present more compelling investment opportunities than Treasuries in today’s environment. Spreads remain at attractive levels; defaults are likely to stay moderate; economic indicators are supportive; and market internals remain supportive. It is worth cautioning, though, that investors buying individual corporate bonds should maintain a selective investment approach and focus on company and industry fundamentals. Ultimately, while distinct risks remain, we continue to see favorable conditions in the corporate bond market.

Unless otherwise noted, figures are in USD.

Analysis: Manning & Napier Advisors, LLC (Manning & Napier).

Manning & Napier is governed under the Securities and Exchange Commission as an Investment Advisor under the Investment Advisers Act of 1940.

Sources: FactSet, Bloomberg, Bank of America Merrill Lynch (BAML), Standard & Poor’s, The Federal Reserve, U.S. Government Printing Office, Moody’s, Institute for Supply Management.

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