I am someone who owns quite a few individual bonds. This includes both investment grade and non-investment grade debt. I am also someone who has historically had perhaps a bit more tolerance than most when it comes to the yield I am willing to accept given a certain level of credit risk. But yields across the fixed income markets are now so low that even I am truly in awe of what investors are willing to buy.
Even though the “BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread” is still well above its all-time low, the “BofA Merrill Lynch US High Yield Master II Effective Yield” keeps touching new historic lows. The reason for this is that benchmark rates are at historically low levels. Therefore, despite spreads on corporate bonds still trading well above their all-time lows, because benchmark rates are so incredibly low, an average to slightly below average corporate bond spread will still result in very low corporate bond yields.
In light of ultra-low benchmark yields, we have all heard plenty of talk about a “bubble” in bonds. But concerning corporate bonds, I was tolerant of lower yields when spreads-to-Treasuries were still at attractive levels. A higher than average spread can cushion a rise in benchmark rates if that rise in benchmark rates is due to an improving economic situation (therefore likely causing a spread contraction). For example, let’s say you purchased a “high-yield” bond at a spread of 500 basis points over Treasuries. Suddenly the corresponding Treasury rises 200 basis points. If you believed all the talk about rising Treasury rates crushing your bond portfolio, you might assume that the 200 basis points rise in Treasury yields caused the price of your corporate bond to decline. But if that corporate bond’s spread-to-Treasuries declined by 200 basis points, to a level of 300 basis points over its benchmark, then the rise in Treasury yields was offset by the spread contraction, and your bond’s price didn’t, as some would have expected, get crushed.
Now, however, we are in a situation in which spreads have narrowed to levels that could, at best, be considered average, and perhaps even be considered slightly below average. When you combine the ultra-low benchmark yields with not-so-attractive spreads, the result is the current historically low corporate bond yields. I would love to purchase Constellation Brands’ recently issued 4.25% 2023 maturing notes (CUSIP: 21036PAL2). But this Ba1/BB+ rated “high-yield” 10-year bond is trading at an unacceptably low yield (for me, at least) of 3.884%. If you thought the 4.25% coupon on Constellation Brands’ junk-rated debt was low, Ball Corporation’s new Ba1/BB+ rated 10-year notes (CUSIP: 058498AS5) were issued with a 4% coupon.
MGM Resorts International, and its B3-rated 6.625% 2021 notes are trading at a yield of 4.895%. For a company with notes that deep into junk bond territory, eight-and-a-half year debt at just 4.895% is amazingly low. Even the iShares High Yield Corporate Bond ETF, HYG, which I own, is now trading at levels at which I wouldn’t dream of buying. A current 30-day SEC yield of 4.50% on a “high-yield” bond fund is so low that it almost seems like a joke. Given its 30-day SEC yield of 3.13%, the PowerShares Fundamental High Yield Corporate Bond Portfolio, PHB, should probably consider dropping the words “High Yield” from its name.
Due to the massive amounts of liquidity that central banks around the world are pumping into the financial markets, it wouldn’t surprise me to see spreads go even lower than today’s levels. But if you are someone who might want to sell an individual bond you purchase prior to maturity, it is important to realize that with spreads heading into below-average territory, your cushion against rising benchmark rates is much lower than it was in recent years.
While lower yields than one might prefer on individual corporate bonds could be tolerated when market-wide spreads were at above average levels, the situation has now changed. It is much more difficult to find individual bonds trading at attractive prices. For the individual bond investor looking to put money to work, you will have to be even more diligent in your search. There will likely be individual companies going through difficult periods that have bonds experiencing notable spread widening. That is where I would focus my efforts when looking for bonds to buy in today’s low-yield, below-average spreads world.
From an individual bond investor’s point of view, let’s hope the insanely low yielding “high-yield” bonds of today don’t stay this way for too long.
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