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May 6th, 2012
Despite the strong showing in the past week or so, equities failed to outperform corporate bonds on a total return basis in April. Fueled primarily by the rally in the underlying U.S. Treasury market, the Barclay’s U.S. Corporate Bond Index gained 1.4 percent while the S&P 500 lost 0.6 percent. Admittedly with much of the gains occurring in the early part of the year after the apparent stabilization of the European Debt crisis, equities have knocked the cover off the ball for 2012 with a year-to-date gain of 12.5% versus 3.5% for Corporate bonds.
In spite of the stellar equity gains for 2012, Corporate Bonds continue to be the leader over the past 12 months with a total return gain of 9.1% versus an increase of 4.8% by equities. Having said this, we paint a completely different picture after we isolate the return that is attributable to just the credit risk which, as an astute bond investor will know, can be achieved by focusing on spreads.
Even with the strong positive gains from a total return perspective, Corporate Bonds have not been able to keep pace with U.S. Treasuries as the yield differential or spread between the two bond sectors widened. The Barclay’s U.S. Corporate Bond Index closed the month of April at a spread of 185 basis points over comparable maturity Treasuries. This spread widened by 8 basis points in April while for the past trailing 12 months, the spread increased by 47 basis points.
Barlcay’s U.S. Corporate Bond Index Spread
As a result for the Corporate Bond market, the excess return over comparable maturity Treasuries has been lackluster, especially when considering the rally in their equity counterpart. For April the excess return, which again, is the return attributable to credit risk, stands at -48 basis points. Similarly, the sector underperformed Treasuries by 151 basis points for the past 12 months.
To illustrate, we compare the spread of the Corporate Bond market with the S&P 500 over the past year. To make it simple, the scale for the spread (on the left axis) is inverted so it corresponds with the direction of the price of the S&P 500 (on the right axis). So as an example, lower spreads normally reflect bullish performance but in this illustration below, a lower number reflects the opposite. As you can see, the two correlate fairly well over time. However, credit has lagged recently.
Corporate Spreads and SPX
This divergence between the Corporate Bond market and equities can be viewed in two ways. First, the credit sector is merely lagging equities and should catch-up eventually which could be driven by the continuation of favorable corporate earnings or a positive reversal of recent economic data such as Friday’s employment figures. The alternative is that investors in the Corporate Bond sector are concerned of risks that the equity markets are not reflecting.
Across the pond in Europe, the capital markets are a mess. Both the United Kingdom and Spain have entered a double dip recession with consecutive quarter negative GDP prints which in turn should exacerbate their respective debt problems. European equities are deep in the red in April highlighted by the Spanish IBEX down 12.4 percent and the Italian MIB falling 8.6 percent. Most importantly, borrowing costs for the debt-heavy countries rose last month. The yield on Italy’s 10-Year jumped 51 basis points to 5.50 percent while Spain’s benchmark note finished April at 5.74 percent, a spike of 41 basis points from the previous month-end.
Given the turmoil in Europe, it’s apparent that investors in the corporate bond market are concerned over the re-emergence of the European Debt crisis. In light of the last bazooka in the European Central Bank’s LTRO program, what is not apparent is the next response by European policy-makers, if any, and when it may take place.
This uncertainty is enough to warrant a defensive stance in the Corporate Bond sector given the risk-reward tradeoff. This can be accomplished in a myriad of ways depending on your investment objectives and time horizon. An astute investor can sell their corporate bond holdings and own Treasury bonds which usually outperform in high uncertainty with the expectation of a better entry point in terms of spread. Obviously, the cost to this approach would be less yield for the investor.
In addition, an investor can reduce their risk by shortening a portfolio’s maturity by selling longer-dated corporate bonds and in favor of credit bonds with shorter tenors that are 5-Years and less. As mentioned several days ago, this part of the curve can capture positive returns by following a Rolling-Down the Yield Curve strategy.
Another strategy is to rotate within a corporate bond portfolio by selling more volatile and risky sectors like Banks and Finance and into the safer Industrial sector. An example would be to sell the more volatile Bank of America 5.625 percent coupon, maturing 10/14/2016, and priced at a spread over Treasuries at 305 basis points. A bond to possibly favor for a defensive strategy would be Dow Chemical 2.50 percent coupons, maturing 2/15/2016, priced at around 70-75 basis points over Treasuries.
Indeed, this slight give-up in yield is noticeable but less volatility of the spread and thus insulating from price risk may be worth it, especially during uncertain market environments. To provide some context, the spread of the 4-Year Dow Chemical bond reached a wide of just 130 basis points when the 4-Year BAC bond hit a peak spread of 629 basis points in late November 2011, which was when uncertainty for Europe was at its highest.
Sell BAC Buy DOW
Equities have had an impressive rally of late fueled by positive earnings results despite facing escalating global headwinds. On the other hand, corporate bonds have not reacted in the same manner. While it remains to be seen which of the two sectors prove to be correct in representing true market conditions, it is apparent that given the risk reward profile for the Corporate bond sector, an astute investor may favor a more defensive approach.