Investors Betting on Corporate Bonds Despite Uncertainty

Investors are increasingly drawn to corporate bonds due to attractive yields and hopes of a soft economic landing leading to potential interest rate cuts by the Federal Reserve. However, there are concerns that these hopes may be unfounded.

Recently, investors have been venturing further along the yield curve and becoming more willing to take on credit risk, according to Jack Fischer, a senior research analyst at LSEG Lipper. So far this year, around $20 billion has flowed into short-intermediate investment-grade debt mutual funds and exchange-traded funds, as compared to $50 billion in the entirety of 2023.

Fischer explains that investors now view longer-duration corporate bonds as safer than they were last year when Treasury bond funds were favored. Duration refers to the measure of interest-rate risk associated with a bond or bond fund's maturity, yield, and other factors.

Steve Laipply from BlackRock also observes investors gravitating towards corporate bonds. The company's largest corporate bond fund, iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), has witnessed $2.3 billion in net flows through February 12, nearly half of last year's total. This trend implies that investors may have more confidence in the economic outlook. Laipply suggests that the possibility of a hard landing may be diminishing, or if a downturn does occur, it may not be as severe as initially predicted.

While the increased interest in corporate bonds has driven up prices and reduced yields, bringing them closer to US Treasury yields, it also exposes investors to added credit and duration risks. If the Federal Reserve maintains higher interest rates for an extended period or if corporate defaults rise due to an economic downturn, bond fund holders could face losses.

According to Guy LeBas, chief fixed-income strategist at Janney Montgomery, the historical spread between corporate bonds and Treasuries is typically around 1.15 percentage points. At present, this spread is around 0.98 percentage points. LeBas suggests that for corporate bonds to be viewed as worth the higher risk, spreads would need to widen to 1.4 percentage points. Only then would he feel compelled to make significant purchases.

Investing in Corporate Bond Funds

When it comes to investing in corporate bond funds, there are a few options to consider. The well-known BlackRock fund currently has a 30-day SEC yield of 5%. Meanwhile, the Vanguard Intermediate-Term Corporate Bond ETF (VCIT), which manages a staggering $46 billion in assets, offers a slightly higher yield of 5.2%. For those looking for a lower-risk option, the iShares Core 1-5 Year USD Bond ETF (ISTB) with $4.7 billion in assets provides a yield of 4.7%.

However, it's important to evaluate the current market conditions before diving into these investments. Phil Kosmala, managing partner at investment consultant Taiber Kosmala, believes that investors are being too optimistic. He anticipates that interest rates will rise and that there could potentially be a recession later this year. In light of this, he recommends staying on the short end of the curve with a particular focus on the $1.3 billion VanEck IG Floating Rate ETF (FLTR) and its attractive 6.2% yield.

While some market watchers are cautious about investment-grade corporate bond funds due to current high valuations, they're not completely ruling them out. They advise nimble investors to be patient and wait for better prices and more certainty from the Federal Reserve before making significant moves. It's crucial to remember that bond yields may eventually decline, but the process will likely be anything but smooth.

For those who prefer high-yield bonds, it may be wise to wait for more clarity in rate outlooks and stable market sentiment. John Jones, an investment advisor representative at Heritage Financial, suggests using a small allocation of high-yield bond funds to supplement income and complement Treasury holdings. His recommended options are the $3.1 billion VanEck Fallen Angel High Yield Bond ETF (ANGL) or the $16 billion Nuveen High Yield Municipal Bond fund (NHMAX) for tax-sensitive clients.

In conclusion, it's crucial to be cautious and strategic when investing in corporate bond funds. Consider the current market conditions, evaluate the potential risks, and seek professional advice if needed. Remember that interest rates can have a significant impact on bond prices, so it may be wise to wait for rate cuts before expecting appreciation in bond funds.