There are no bad bonds, only bad prices. So Dan Fuss, Loomis Sayles’ vice chairman, has often observed—a lesson gleaned from more than six decades of experience managing corporate bond portfolios. After what seems likely to go into the books as the worst first half of the year for fixed-income markets on record, prices now look a lot better from the standpoint of investors aiming to buy low.
The savvy ones that sold high were major corporations that issued bonds at record-low yields in the past two years. Bond prices move inversely to their yields. So, with benchmark 10-year Treasury yields roughly doubling since the start of the year, to over 3%, and corporate-credit yield spreads increasing over risk-free government securities, corporate bond prices have fallen sharply.
A couple of outcomes emerge. First, high-yield bonds now live up to their name, providing much higher income, north of 8% on average. Second, the sharp drop in high-grade bond prices may attract a new set of buyers: issuers of the debt themselves.
On the latter score,
Bank of America
credit strategists Oleg Melentyev and Eric Yu see a possible rise in buybacks among what they estimate to be over $300 billion of liquid, investment-grade corporate bonds trading at or below 75% of face value.
“These are the highest quality names,” they write in a research note, citing companies like
(VZ). “These are the companies with hundreds of billions of dollars of cash, who are staring at their bonds trading at essentially distressed levels.” That presents blue-chip companies with the opportunity to gain a rare, one-off windfall from buying back their debt at a discount, they add.
The finance teams at Big Tech companies did a great job for shareholders last year by obtaining cheap capital when yields were down in the 1%, 2%, and 3% ranges, says Cliff Noreen, head of global investment strategy at MassMutual. Repurchasing those bonds now at discounts produces a high return on capital, he adds in an email.
As for speculative-grade debt securities, it’s been a dreadful first half, with the popular
iShares iBoxx $ High Yield Corporate Bond
exchange-traded fund (HYG) suffering a negative total return of 13.3% since the beginning of 2022 through June 22, according to Morningstar.
The flip side is that yields are sharply higher, which means two things, according to several market pros. In addition to substantially larger current income, based on history, investors might look forward to high total returns to offset potential defaults down the road as well as a margin of safety.
The selloff in speculative-grade bonds this year has produced a doubling in yields, to 8.4%, writes Rachna Ramachandran, a researcher in structured products and high-yield strategies at GMO. In the past 30 years, only during the 2008-09 financial crisis and the March 2020 Covid-19 market maelstrom have high-yield bonds produced a doubling in yields so quickly, she notes.
When speculative-grade bonds start with yields between 8% and 9%, total returns in the next 12 months historically have been strong; 13% is the most frequent outcome over the past three decades, with returns ranging most often between 7% and 17%, according to Ramachandran’s research note.
Moreover, a higher starting yield can absorb a lot of bad developments. She calculates an 8.4% yield can offset a 12% default rate (with a 30% recovery rate on defaults), which would be a vastly worse outcome than the 1% actual default rate in the past year. Beyond defaults, the market would have to sell off further, raising yields by another 1.95 percentage points, before an investor would be underwater, she adds.
Anders Persson, chief investment officer for global fixed income at Nuveen, agrees that the surge in yields in speculative-grade credit points to strong future returns, while providing a margin of safety against future defaults.
Within the high-yield bond sector, he favors the high end of the quality spectrum. Yields on BB-rated bonds have actually increased more, by 4.3 percentage points, to 7%, than the overall speculative-grade market, he writes in an email. After previous episodes of massive yield rises in 1990, 2008, and 2020, BB corporates returned an average of 30%.
In contrast to the high-yield bond market, the leveraged-loan market has been pressured this year because its credit quality has declined from a higher percentage of lower-rated borrowers, he says. But Persson notes he would add to exposure to loans, which have floating interest rates that should boost returns during the Federal Reserve’s rate-hiking cycle.
Last year’s historically low bond yields produced bad prices for fixed-income investors. Today’s lower prices and higher yields add up to something better.
Write to Randall W. Forsyth at [email protected]
This story originally Appeared on Yahoo