Corporate bond investors still reeling as economic recovery picks up

One year ago, financial markets were in meltdown as coronavirus spread across the globe.

The Federal Reserve had slashed interest rates to support a cratering US economy. The 10-year Treasury bond yield — the linchpin metric for markets — had fallen below 1 per cent for the first time ever earlier in the month, as investors flocked to the haven asset. And higher-quality corporate bonds considered investment grade hit a nadir on March 20 as concerns over companies’ vulnerabilities mounted.

One year on, with the rollout of coronavirus vaccines giving hope to an economic recovery bolstered by fiscal stimulus, corporate bond investors are still unhappy.

Investment-grade corporate bonds have suffered total losses of 4.8 per cent for the year to Wednesday, when the Federal Reserve board of governors met to announce revisions to its monetary policy framework. That marked the worst start to the year in data going back to the early 1980s, according to an index run by Ice Data Services. 

At the same point last year, the market was down 4.5 per cent for the year, with the coronavirus induced sell-off gaining speed in the following days. Still, it’s an oddly similar outcome given the economy is now in resurgence, not turmoil. 

Having cheered the US Federal Reserve’s swift and comprehensive response a year ago that rescued corporate debt markets and helped erase their losses, investors are now lamenting those same policy measures eating into their returns this year. 

Fearing rising inflation is cutting into the returns earned from fixed-income debt, investors are calling for details on when crisis measures like the Fed’s bond-buying programme will be pared.

However, on Wednesday, the Fed offered them little comfort. While acknowledging improvements in the US economy and sharply revising its growth projections higher, the central bank resolved to keep emergency policy measures in place until “substantial” further progress has been made.

“The Fed needs to recalibrate the emergency policy settings they put in place last year,” says Bob Miller, head of Americas fundamental fixed income at BlackRock. “If the Fed remains stubborn about recalibration, then I think it could lead to more volatility.”

Part of the problem for credit investors lies in just how unusually rapid the recovery has been. 

Expectations of growth and inflation as the US economy reopens are rising, pushing government bond yields higher. That’s further supported by fresh fiscal stimulus from the US government, and the Fed’s continued easy monetary policy stance. 

Benchmark 10-year US Treasury yields marched upward last week following the Fed meeting, hitting their highest level since January last year.

Typically, this would be accompanied by a reduction in credit spreads, or the premium above government bond yields demanded by investors to lend to companies, as confidence in corporate America returned. But spreads are already very low, dragged down by the Fed’s support for the market creating early confidence in companies’ ability to repay their mammoth debts built up last year. 

While this can be read as broadly positive, for investors it leaves little cushion to absorb the rise in interest rates associated with a recovery. Rising Treasury yields transfer directly to rising corporate borrowing costs, and falling corporate bond prices. Investment-grade corporate bond yields have risen from 1.78 per cent to 2.31 per cent this year, even though spreads remain virtually unchanged.

The effect is further exemplified by the comparable outperformance of lower-quality, higher-yielding bonds. In fact, it’s the very lowest-rated debt that has performed the best so far this year because it carried the highest spread above Treasury yields that has compressed as the outlook for the riskiest borrowers has improved. 

However, there are signs that even this cushion is wearing thin, with high-yield bond returns sitting just above zero for the year, down from over 1.4 per cent in mid-February.

Investors had hoped for acknowledgment by the Fed of the risks posed by rising Treasury yields when the central bank met this week, for fear that the sell-off could accelerate.

Sadly for bond investors, Treasury yields are not the Fed’s only concern. It remains dismissive of what it sees as transitory inflation pressure, focusing instead on bolstering support for the nascent economic recovery.

The US unemployment rate remains at 6.8 per cent, and while inflation is expected to rise, year over year core inflation was just 1.4 per cent last month, still below the Fed’s target of 2 per cent. 

After the Friday March 20 nadir for corporate bonds last year, the Federal Reserve announced sweeping measures to prop up markets on the following Monday. One year on, the Fed is so far less willing to come to investors’ aid.

joe.rennison@ft.com