Evening Brief – 11.10.23
IG Corporate Bonds – An Opportunistic Investment
The bond market is often the default mechanism for investors concerned with capital preservation. However, long-term US Treasury yields will likely remain elevated due to the long-term concerns linked to a soaring government budget deficit.
Meanwhile, with China and Japan offloading US Treasury securities and the Treasury issuing trillions of dollars in new paper, the pressure on 10-year or longer maturities may remain high. In contrast, the short end of the curve predicts that the Fed will begin cutting interest rates in the middle of 2024 at the latest.
The chance of a quarter-point interest rate cut is just above 50% at the May 2024 FOMC meeting, according to the CME FedWatch Tool, and the probability jumps to nearly 80% for the July meeting.
If the weaker-than-expected October payrolls data starts a trend, then the rate-cut probabilities appear accurate. Investors may want to be in front of this potential outlook by six months.
Along with the softening labor markets and recent weaker-than-expected manufacturing data, the about-face in the fourth-quarter GDP estimate by the Atlanta Fed’s GDPNow shows the U.S. economy growing at just a 1.2% rate, down from 4.9% in the third quarter.
Purchasing investment-grade corporate bonds with maturities of two to four years looks attractive if the economy weakens. If the Fed starts cutting interest rates by mid-next year, riding the curve from six-month to one-year T-bills will be done at lower rates than where they trade now.
A tiered 2-, 3-, and 5-year US Treasury portfolio pays a blended yield of 4.66%, while a tiered 2-, 3-, and 4-year investment grade corporate bond portfolio pays 5.83%.
U.S. Treasuries are issued at par every week, so investors receive a total average of 4.6% interest income. Most corporate bonds in the two- to four-year range are trading at discounts to par since they were issued when rates were lower. Therefore, the average distribution rate is about 3.8%, but the yield to maturity (total return) is around 5.83%, as there could also be capital appreciation.
In contrast, with high-grade corporate debt yielding 6% on a total return basis for two to four years, putting money to work in a company with a strong balance sheet makes sense.
While there is no guarantee that Treasury yields will not rise further, the risk of short maturities is well-defined, and a return of around 6% for two- to four-year corporate debt may be what the doctor ordered.