Demand for Corporate Bonds Drives Inflation-Adjusted Yields to Zero
The development highlights how demand for fixed-income assets is reducing their potential returns
The average U.S. investment-grade corporate bond now yields less than a key measure of investors’ inflation expectations for the first time on record, highlighting how demand for fixed-income assets is reducing their potential returns.
As of Friday, the annual expected inflation rate over the next decade—derived from the difference in yield between nominal and inflation-adjusted 10-year U.S. government bonds—stood at 1.89%, according to the Federal Reserve Bank of St. Louis. The average investment-grade corporate bond yielded just 1.85%, according to Bloomberg Barclays data.
So-called real yields—or the return investors can expect on bonds after adjusting for inflation—have been below zero for months on U.S. government debt. But last week marked the first time in records going back to 2003 that the phenomenon ever extended to a broad index of corporate bonds.
The two situations are related; negative real yields on U.S. Treasurys drive investors to buy riskier assets in search of better returns. Many have turned to corporate bonds, driving yields to new lows in recent months, investors and analysts say.
The yield on the benchmark 10-year Treasury inflation protected security—a proxy for real Treasury yields—is currently around minus-0.97%. That means investors can still pick up a meaningful amount of return by buying corporate bonds.
“Most individuals and institutions don’t have the luxury of being [invested in] 100% equities,” said Nicholas Elfner, co-head of research at Breckinridge Capital Advisors, which specializes in investment-grade bonds.
The choice, therefore, isn’t whether to buy corporate bonds at all, but how much to purchase relative to Treasurys, and investment-grade bonds remain “a way to add some incremental yield,” Mr. Elfner said.
The most recent decline in real corporate yields has been helped along by a burst of economic optimism. Over the past month, yields on 10-year U.S. government bonds have climbed toward 1% in response to progress toward coronavirus vaccines and new spending legislation designed to tide the economy over until those vaccines are widely distributed next year.
In recent trading, the yield on the benchmark 10-year U.S. Treasury note was 0.929%, according to Tradeweb, down from 0.967% Friday but up from 0.768% on Nov. 4. Treasury yields tend to rise when the economic outlook improves, because faster growth can lead to a higher rate of inflation and eventually interest-rate increases from the Federal Reserve.
The same developments have fueled a climb in market-based expectations for inflation. Even so, corporate-bond yields have fallen because the improved outlook has made investors more confident that businesses will meet their debt obligations.
For businesses, the decline in corporate-bond yields is welcome news, allowing them to borrow at rates that would have been unthinkable just a few years ago.
Last week, Bank of New York Mellon Corp. issued $750 million of three-year bonds at a 0.386% yield, the lowest ever for that maturity, according to LCD, a unit of S&P Global Market Intelligence. In the secondary market, a Microsoft Corp. bond due in 2022 last traded on Dec. 1 with a 0.196% yield, just 0.03 percentage point above the comparable U.S. Treasury yield, according to MarketAxess.
Andrew Karp, head of global investment-grade capital markets at BofA Securities, said that investment-grade corporate-bond issuance is likely to decline next year from its record-smashing pace this year, in large part because companies already have done so much to raise cash and extend their debt maturities in recent months.
Still, he said, companies are “definitely still intrigued by the opportunity to lock in long-term rates at what are still historically attractive levels.”