As those who follow the bond market know, during the second quarter of 2013, yields on U.S. Treasury securities rose notably. But even with the 10-year Treasury topping 2.70%, and the 30-year topping 3.70% in early July (yields even higher when calculating their taxable-equivalent yields due to state and local tax exemptions), many investors still didn’t find the bonds particularly enticing. I didn’t bother purchasing any Treasuries either. Instead, I focused my efforts on the corporate bond market.
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One of the interesting things about the second quarter rise in benchmark Treasury rates was that it was accompanied by widening corporate bond spreads. Typically, we see rising Treasury yields as the result of a strengthening economy. But that’s not what was happening in Q2. Instead, the bond market was reacting to the possibility of the Fed’s tapering its QE purchases. And with that bond market response came widening corporate bond spreads, something that happens when investors fear a weakening economy. While I am of the view that tapering QE is a form of tightening monetary policy, tapering QE is very different from a rate-hike cycle, which will not be in the cards for a long time to come. This is why I viewed the combination of rising benchmark rates and widening corporate bond spreads as a buying opportunity.
A Fed rate-hike cycle will only occur after a self-sustaining recovery has taken hold in the U.S. economy. When that happens, corporate bond spreads will likely head much lower (narrower) than they were near their peaks in Q2 and will probably end up even lower than they were at their lows in Q2. Therefore, buying corporates after spreads widened and Treasury yields rose was similar to buying corporates had there been no widening in spreads (or a contraction in spreads) and a much greater rise in Treasury yields. I don’t think there is much danger of Treasury yields exceeding their post-financial crisis highs at any point in the coming years. With that in mind, there were many single-A- and triple-B-rated corporates that, a few weeks ago, were offering quite compelling yields. Yes, corporate bond yields can certainly head higher than they were a few weeks ago. But the question investors should ask themselves is how much higher yields might realistically head and whether the opportunity cost of waiting for those yields is worth not purchasing today (or a few weeks ago).
On June 21, with long-term Treasury yields about six basis points lower than they closed this past Friday, I purchased AT&T’s September 1, 2040 maturing notes, CUSIP 04650NAB0, at an after commissions yield-to-worst of 5.386%. Since I made that purchase, benchmark Treasury yields have moved slightly higher, but the yield on the AT&T notes has dropped roughly 22 basis points (as of Friday, July 26’s closing offer). An investor who wanted to purchase AT&T’s notes on the same day I did but feared Treasury yields would keep rising would have been correct about rising Treasury yields. At the same time, that investor would have watched AT&T’s yield begin to drop, despite a further rise in Treasury yields. Why did that happen? Spread contraction.
On July 8, I purchased McGraw Hill Financial’s November 15, 2037 maturing notes, CUSIP 580645AF6, at an after commissions yield-to-worst of 6.659%. Since the time of purchase, benchmark yields have declined about three basis points. The broker from whom I purchased the notes, however, is offering them at a yield of 6.337%, 32.2 basis points lower than the yield on July 8. Interestingly, I can find offers at yields as high as 6.488% (as of Friday’s close), “only” 17.1 basis points lower than the yield at which I purchased the notes. Again, spread contraction was the reason behind the larger drop in the corporate bond yield versus Treasury yields. But this example also brings up another noteworthy point: The rather large difference between the best offers at various brokers shows the importance of remembering that the corporate bond market is still quite fragmented. Additionally, when you perceive value in a bond’s price/yield, reacting quickly can be worthwhile.
Finally, on June 21, I also purchased Rio Tinto Finance’s November 2, 2040 maturing notes, CUSIP 767201AL0, at an after commissions yield-to-worst of 5.275%. Similar to the AT&T notes mentioned above, benchmark Treasury yields have risen about six basis points since my Rio Tinto purchase. The yield on the Rio Tinto notes, however, has fallen about 19 to 22 basis points, depending on the broker. Again, spread contraction is the reason for the dichotomy.
So what’s the moral of this story? After doing your due diligence on the financial health of a company, don’t just focus on benchmark yields or on corporate bond spreads when determining your entry point. It is a combination of factors that should be considered, including benchmark yields, corporate spreads, the reasons for movements in benchmark yields and spreads, and the likelihood that the current movements/correlations in benchmark yields and spreads will continue. Moreover, don’t forget to make sure that the yield is something with which you can live, if you held the bond to maturity. Just because a bond may have peaked in yield doesn’t mean it is worth buying. Personal investment objectives should, of course, also play a role in your purchase decision.
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