Don’t Ask Santa for Corporate Bonds
There may be better opportunities to buy investment-grade debt next year
Should investors buy corporate bonds for Christmas? The contrarian case in favor is getting stronger, but it is still wise to wait for New Year sales.
It’s been a really bad year for U.S. investment-grade debt, and most professional money managers think the rout will continue, according to a Bank of America Merrill Lynch poll in early November.
But some plucky investors are now getting interested again. The main temptation is sheer value: Investment-grade bonds now yield 4.4%, the highest since mid-2010. In a world where a lot of bonds still offer negative yields, that’s hard to turn down.
An added attraction is last week’s hint by Federal Reserve Chairman Jerome Powell that interest-rate rises could soon end, which pushed down government-bond yields. Despite worries about global growth and high stock-market valuations, there’s little to suggest that the U.S. economy is about to fall into a recession or that inflation is about to surge.
Yet caution may be in order, at least for a little while.
One of the main reasons why investment-grade debt has done badly over the past year is that it had done amazingly well in previous years. Unlike stocks, corporate bonds can’t go up forever. Eventually, their yields get so close to those of risk-free government paper that it makes no sense to buy them anymore.
This spread versus risk-free assets was simply bound to widen from record lows as interest rates rose. And it remains at very low levels historically. A Bank of America index of spreads stands at 1.3 percentage point, compared with the 1.7 percentage-point average of the past decade.
Furthermore, the apparent value on offer isn’t as clear-cut for overseas investors. Higher short-term rates in the U.S. have massively increased hedging costs for those who want to buy U.S. bonds without betting on the dollar—which is often done by rolling short-term currency hedges. This has prompted European and Japanese investors to sell a lot of U.S. bonds, official data suggest. They actually lose money, net of hedges, by buying Treasurys instead of German or Japanese government debt.
Hedging costs are rising even further as 2018 draws to a close because of a technical quirk of the financial system. Global banks typically elude regulators by shrinking their balance sheets at year-end, making dollars scarcer. One side effect is to reduce the collateral required for dollar currency hedges. This problem should ease a bit in January, but hedging costs will remain high given the big gap between central-bank policy in the U.S. and elsewhere.
Investors should reassess whether there are bargains after the holiday season.