What an Economic Rebound Could Mean for Corporate Bonds
Risks and rewards in the 2021 corporate-bond market.
Corporate credit spreads have completely recuperated and are back to pre-pandemic levels--a notable move since it was only March 2020 when they reached their second-widest level in 20 years. As such, barring a sharp increase in underlying interest rates, we expect that the corporate-bond markets are setting up to provide a return that's equal to, or slightly lower than, their current yield. As of Jan. 11, 2021, the yield of the Morningstar US Corporate Bond Index (our proxy for investment-grade corporate bonds) was 1.88%, and the yield of the Morningstar US High-Yield Bond Index was 4.38%.
While the issuers that have suffered the most from the pandemic will continue to face headwinds in the first half of 2021, those headwinds will turn into tailwinds in the second half. Though there likely will be additional credit-rating downgrades over the next few months and the default rate will remain slightly elevated, we expect that broad vaccine distribution will pave the way for economic normalization, which will quickly help to bolster the credit metrics of those struggling companies.
The corporate credit spread is the extra compensation provided to investors to offset the credit risk of the corporate issuers. And even though corporate credit spreads are still near their lowest quintile of the past 20 years, the strong economic rebound we expect in 2021 and continued momentum in 2022 will provide support for credit metrics, and the default rate should drop to its historical average by the end of this year.
As of Jan. 11, 2021, the average corporate credit spread over U.S. Treasuries for investment-grade bonds was plus 97 basis points and plus 377 basis points for high-yield bonds. These corporate credit spreads over the past year are shown in the chart below.
Why We Expect a Strong Corporate-Bond Market in 2021
In addition to the strong economic growth and normalization we expect in 2021, there are a number of other factors that will help to support credit risk. For instance:
What Are the Risks for Corporate Bonds in 2021?
Still, the greatest risk in 2021 for investors is rising interest rates. As yields have dwindled, the duration of corporate bonds has increased--and longer duration means greater price volatility.
With their lower coupons, investment-grade bonds have longer durations and are more sensitive to changes in interest rates than high-yield bonds. The current duration of Morningstar's investment-grade index is 8.5 years, and the high-yield index's is 3.7 years. This roughly means that if the yield were to jump 1%, the value of the investment-grade bonds in the index would fall by approximately 8.0% and high-yield bonds would fall about 3.5%. Depending on how long it takes for interest rates to rise, some of the losses could be mitigated by the yield carry (interest payments) of the bonds in the index. For investors concerned that interest rates could spike this year, short- and medium-duration funds are much less sensitive to rising rates.
Rising interest rates are typically indicative of the economy improving, so this would mean that corporate credit risk should be declining. As credit risk declines, investors do not require as much compensation for the risk of a potential future default. As corporate credit spreads tighten, it helps to offset some of the increase in interest rates. Conversely, declining interest rates are typically indicative of a weakening economy and rising credit risk, which then is reflected in widening credit spreads.
Another potential risk to corporate bondholders this year is a resumption in debt-funded acquisitions, which typically result in heightened debt leverage and higher credit risk. However, after living through the free-fall and liquidity constraints of early 2020, management teams will be especially wary of leveraging up their balance sheets too much and will be unlikely to risk credit-rating downgrades. Corporations could be willing to issue debt to repurchase shares and leverage up their balance sheets at the expense of their credit ratings, but we expect those instances to be limited in 2021.
How Do Current Corporate Credit Spreads Compare With Historical Averages?
In bond vernacular, corporate credit spreads are expensive as the low spreads provide only limited compensation for credit risk. Over the past 20 years, investment-grade spreads have been lower than they currently are only about 15% of the time. In the high-yield market, credit spreads have been lower only about 20% of the time. As such, we do not expect credit spreads to tighten much from here.
Currently, the average corporate credit spread of the investment-grade index is plus 97 basis points. As shown below, this is substantially tighter than the average we have seen over the past 20 years; however, we note that the average is skewed about 10 basis points higher from the worst of the global financial crisis. The tightest that this index ever traded was plus 80 basis points in February 2007.
The current corporate credit spread of the high-yield index is plus 377 basis points. As shown below, this is also substantially tighter than the average we have seen over the past 20 years; however, the average is skewed about 40 basis points higher from the worst of the global financial crisis. The tightest that this index ever traded was plus 241 basis points in June 2007.