“It’s Time to Buy Bonds,” proclaims the cover of this week’s issue. Barron’s. A recent New York Times The headline says: “Bonds Have Been Horrible.” Now is a good time to buy. The telegraphAmbrose Evans-Pritchard of , chimes in: “It looks like the perfect entry point.”
This could very well turn out to be great advice. The Fed appears to have reached or near the end of the interest rate tightening that has pushed yields to levels that ultimately look appetizing. But if you are planning to engage in a short-term trade, pay close attention to which bonds you buy.
You may be thinking, “If the ICE BofA US Treasury Index yield is attractive at 5%, investment grade corporate bonds (the ICE BofA US Corporate Index) at over 6% are even better.” And the ICE BofA US High Yield Index offers 9% and change. Why not get the most current income available while I drive up bond prices as interest rates start to fall? »
The problem is that in some years, corporate bond prices move in the opposite direction as Treasury bonds. During the recession year of 2008, for example, Treasuries experienced a 9.2% price gain, while Single-A corporate bonds decreases by 13.3%. Based on this type of result, the “sweet spot” for establishing gains on these low-yielding Treasury bonds could also mark the start of a painful decline in corporate issuance.
The attached table covers all years for which all relevant data is available. It shows that bonds in all rating categories sometimes fell when Treasuries rose or vice versa. The percentage of years in which prices moved opposite to Treasury prices increased as ratings declined, from 11.5% for AAA corporate bonds to 69.2% for AAA corporate bonds. rated CCC, CC or C. For investment grade bonds collectively (those rated AAA to BBB), the ratio was 23.1% compared to 61.5% for junk or high yield bonds, rated BB to CCC-C .
How is all this possible? Almost every day we read in the financial press that when interest rates fall, bond yields rise. The Treasury index yield fell from 3.6% to 1.6% in 2008, so Treasury prices naturally rose. Why Investment Grade Corporate Bond Prices Have Risen down This year?
The explanation is that unlike U.S. Treasury bonds, which are supposed to carry no risk of default, corporate bonds expose their holders to the possibility that the promised interest or principal will not be paid in full and on time. To compensate for this risk, investors demand higher returns on companies. The difference between corporate yield and Treasury yield is called the “spread.”
When the United States entered a deepening recession in 2008, leading to increased default risk, the spread between corporate bonds and Treasuries more than doubled from 2 .2 to 5.9 percentage points. This 3.7 percentage point increase more than offset the 2 percentage point decline (from 3.6% to 1.6%) in the underlying Treasury yield. As a result, the yield on investment-grade companies rose – from 5.8% to 7.5% – at the same time as the Treasury yield fell. The prices of the two types of bonds therefore moved in opposite directions.
The risk of default is greater as one moves down the rating scale, so the frequency of price movements opposing Treasury price movements is highest at the bottom of the speculative category , i.e. CCC-C. But even the safest, AAA-rated corporate bonds sometimes experience a price drop when Treasury yields fall.
The good news is that investors who purchased corporate bonds in early 2008 and maintained a long-term perspective have done well. Over the five years from 2008 to 2012, the investment-grade index grew at a rate of 1.9% per year, about the same as the Treasury index’s 2.1% annualized gain . Thanks to their higher current income rate, companies posted a higher total return: 7.7% per year compared to 5.4% for Treasury bonds. This is how it works in the long run; businesses are riskier and therefore offer a higher return.
Bottom line: November 2023 could very well prove to be an excellent time to buy bonds. But measuring your success depends primarily on two factors, namely the bonds you buy and the length of time you hold them.