Quality bonds should hold up better than stocks, right? Especially if the defaults aren’t really the concern.
But that hasn’t been the case lately for debt issued by many Fortune 500 companies, a sector that’s been hit particularly hard since the Federal Reserve changed stance to urgently cool inflation.
US investment-grade corporate bonds, sold by many large companies in the S&P 500 Index SPX, +1.12%, have posted a negative total return of -10% so far in 2022 (see chart) after they posted their worst quarterly loss since the global financial crisis, Mizuho said.
Only a few financial investments have so far recorded even slightly positive returns in 2022.
Mizuho Securities
The flight in high-quality corporate bonds compares to a total return of about -6% for the S&P 500 index SPX, +1.12%, and a -6% negative performance for bonds issued by municipalities and high-yield companies.
“We’re in a difficult environment,” said Jack McIntyre, portfolio manager at Brandywine Global Asset Management. “Bonds will sell off, stocks will sell off. The real return on cash is negative.”
McIntyre believes that with yields steadily rising, bonds will eventually be a “great buy,” although he anticipates bumps along the way.
For one, the Fed needs to figure out how much to raise interest rates to contain inflation at a 40-year high while shrinking its nearly $9 trillion balance sheet without hurting the economy.
See: Yellen says it’s not impossible for the Fed to engineer a soft landing for the US economy
Many on Wall Street now expect the Fed to hike interest rates by half a point in May while embarking on “quantitative tightening” or reducing its balance sheet at its fastest pace ever.
The hope is that interest rates, including the benchmark TMUBMUSD10Y 10-year government bond yield of 2.682%, will stabilize and help put bonds on a firmer footing. Corporate bonds and other debt instruments associated with credit risk are priced at a spread, or premium, above the Treasury risk-free rate, which has skyrocketed this year as Fed officials have become tougher on inflation.
A turning point?
Corporate defaults have remained low after an early spate during the pandemic and could remain so for a number of years given the ultra-low-cost financing many large companies have secured over the past two years.
That doesn’t make it any easier for investors to hold trillions in bonds at low coupons that won’t be redeemed for a decade or more, or longer in some cases.
“I think individual investors are still licking their wounds given negative total returns,” said Travis King, head of investment-grade credit at Voya Investment Management. “But we think that with yields around 4%, it looks like a better entry point, especially when the Treasury market is stable.”
King also said other positive signs emerged in the form of a surge in overnight buying of high-quality corporate bonds by Asian investors.
“It’s definitely supported our market,” King said, although he was also concerned about increased hedging costs that could dampen foreign appetites. “If the Fed hikes rates by 50 basis points across multiple meetings, those hedging costs become more expensive.”
The inflation path is everything
A big focus going forward will be the trajectory of inflation after US consumer prices rose 8.5% yoy in March, the fastest pace since January 1982.
David Norris, head of US credit at TwentyFour Asset Management, sees hope in falling used-car prices and other segments of the consumer price index, but also potentially greater stability from a 10-year Treasury yield around 2.7%.
“At the end of the day, I think we’re close to peak inflation at 8.5%,” Norris said over the phone. While the Fed plans to frontload rate hikes this year, he also expects the central bank to reassess the state of the economy over the next two quarters and perhaps decide that interest rates need not be adjusted aggressively higher.
“Over time, we’ll see how the economy can handle rate hikes,” Norris said.
Brandywine’s McIntyre warned of the unusual times. “It’s kind of a Volcker moment, and marry that with a Putin moment,” he said, referring to the rise in oil prices CL.1, -1.19% and other commodities after Russia’s invasion of Ukraine and the Recession in the early 1980s triggered by former Fed Chairman Paul Volcker’s struggle with high inflation.
“Something’s going to break,” McIntyre said. “Ideally if it’s inflation then it means the Fed has imposed the landing.”