The fixed income sector is often seen as the stable, income producing portion of a portfolio. Many investors assume that volatility will be low and returns, while not spectacular, will be steady. Perception, however, is not always consistent with reality, as fixed income investors have experienced numerous volatile periods over the last 35 years. But the opportunities volatility brings can be rewarding for long-term investors.
Current fixed income valuations may offer investors the greatest opportunities seen in this sector in a very long time. Not surprisingly, U.S. Treasury securities have recently posted very strong returns--a result of a significant flight to quality during the credit crisis. On the other hand, the performance of many other sectors of the fixed income marketplace has been well below historical norms. And as we go to press in January 2009, the spread on many fixed income asset classes is at all-time highs.
In this environment, comparing current valuations to historical norms can provide a framework for evaluating the relative attractiveness of different asset classes. With that in mind, we'll focus on one important sector of the fixed income market: investment-grade corporate bonds.
Investment-Grade Corporate Bonds
Although these high-quality bonds have traditionally underperformed during economic downturns prior to 2008, there had only been four negative return years since 1973. But the performance of corporate bonds in 2008 is the worst on record.
Part of the reason for their poor performance last year is a general risk aversion among investors. Market participants have sold all risky assets, causing spreads between investment-grade corporates and Treasury bonds to widen dramatically. A second important cause for the negative performance of corporate bonds has to do with the industry profile of issuers. Financial companies are very large issuers of corporate bonds, and all of the largest financial companies have carried investment-grade ratings. This means that the performance of financial company bonds has dominated the performance of the investment-grade market as a whole. During the credit crisis, financial companies were the worst performers in the class, with multiple issuers declaring bankruptcy, requiring government assistance, or battling rumors of financial difficulty. Even relatively stable financial companies such as JPMorgan and Wells Fargo saw prices on their bonds decline dramatically.
Corporate Bond Spreads
The Merrill Lynch (ML) U.S. Corporate Index tracks the performance of investment-grade corporate debt. As such, the performance of the index provides a comprehensive overview of the investment-grade corporate bond market. The chart below displays the monthly option-adjusted spread (OAS) of the ML Corporate Index from 1996 through October 2008. The OAS indicates the added compensation investors require to purchase corporate bonds as compared to risk-free U.S. Treasury securities. When the OAS is low, corporate bonds are "expensive;" when it is high, corporate bonds are "cheap."
Since 1996, the OAS has fluctuated between 54 and 606. During that time, there have been 60 months during which the OAS was less than 100, while there have only been eight months in which the OAS exceeded 250. Each of those eight months has occurred since February 2008, and the months of August, September and October are the three highest readings on record. Clearly, spreads--as measured by OAS--are extremely wide compared to where they have been during the past 12 years.
OAS spreads could certainly move higher, which would likely indicate negative price-performance for corporate bonds. However, even if investors who purchase corporate bonds now do not benefit from a return to more normal valuations, performance still may be attractive. That is because historically, the long-term return for a broad-based basket of fixed-income securities has been reasonably approximated by the starting yield for that basket of securities. In other words, the return on fixed income securities is strongly influenced by the income component. As we write this (mid-December 2008) the yield on the investment- grade corporate index is 8.75%. This means that even in the absence of a return to more normal valuation levels, investors may receive equity-like returns from an asset class that historically has displayed much lower levels of volatility than equity securities.
Historical Corporate Bond Performance
Most investors are aware that periods of poor performance are often followed by rebounds of extremely strong performance. With that in mind, let's examine the long-term performance of the investment grade corporate bond index in order to determine whether previous periods of negative performance have been followed by strong returns.
Since 1973, there have been four years in which the investment- grade corporate bond index displayed negative total return: 1974, -4.74%, 1979, -2.21%, 1994, -3.34% and 1999, -1.89%. Since trying to predict a precise bottom in the financial markets is exceptionally difficult, we look at performance for a three-year period following a decline allowing for the likelihood that investors will not enter the market at precisely the right moment, and that markets may in fact continue to move lower for a period of time following any purchase.
For the three-year period immediately following a down year, the average annualized return for the corporate index was 11.46%--a very good return for nearly any asset class and exceptional considering that the asset class in question is high-grade fixed income. During several of these periods, investors benefited from a sharp decline in interest rates in addition to tighter corporate spreads. With overall interest rates currently very low, investors are less likely to receive this boost in the future, but valuations may be sufficiently attractive to produce excellent corporate bond returns even in the absence of declining interest rates.
Historically, returns have been strong following a negative year in the investment-grade corporate bond market. A simple average of the four previous declines shows that the average loss during those years was -3.04%. In hindsight, those previous losses now appear quite tame compared to 2008's performance. Year to date through October 31, the corporate index was down -15.02--by far the worst performance in the 35 years that Merrill Lynch has been tracking this market.
In 1974 and 1994, performance was extremely strong in the year immediately following a negative year. However, in 1979 poor performance continued for two more years before exceptionally strong returns were posted in year three, while performance in 1999 was consistent in each of the three years following the decline.
The credit crisis and dramatic reshaping of the global financial system have called into question the viability of a number of previously well-respected corporations. In addition, the global economy is slowing, and previous recessionary periods have often resulted in higher levels of corporate defaults. Nevertheless, the credit crisis could present an extraordinary opportunity to purchase investment-grade corporate bonds. Valuations appear to be extremely attractive, and if the credit crisis moderates and the global economic slowdown is not too severe, corporate bonds could post superior returns in the years to come.
Brian Perry (firstname.lastname@example.org) is a vice president and investment strategist at Chandler Asset Management in San Diego.