December 2017

This week we will put our tour of the FANG stocks on brief hiatus and focus instead on a vastly different but increasingly popular investment security—corporate bonds.

Bonds, as you may know, are a form a debt capital (as opposed to equity capital).

When an investor purchases a bond issued by a corporation, he is not receiving any equity in the corporation. He is giving the corporation a loan with the intention of being repaid in full and with interest. In recent months, corporate bonds have become so popular that the demand for them has driven down their interest rates.

The Wall Street Journal reported recently that the spreads between the interest offered on US-backed Treasury securities and the interest offered on corporate bonds is the lowest it’s been since 2007.

Higher Demand = Lower Interest Rates

Corporate bonds are similar to treasuries (bonds issued by the government) in that the interest rates they offer are inversely proportionate to demand levels. If everyone and their neighbors wanted to purchase corporate bonds for Apple Inc., then Apple would be able to sell off bonds at very low interest rates.

On the other hand, if the company was less well known or had more questionable creditworthiness, then they would likely be forced to offer higher interest rates on their bonds in order to attract buyers.

Interest rates for treasury and corporate bonds have dropped, signifying an increase in interest.

This same principle applies to Treasury securities; when demand is high, interest rates are “bid down” by the market.

Even investors who do not purchase Treasury securities will pay close attention to Treasury interest rates, because they are viewed as a kind of barometer for the stock market. For example, when interest rates climb higher on the 10-year Treasury note, it is regarded as a sign of a healthy stock market—the assumption being that when money is flowing into stocks, Treasury interest rates must increase in order to remain a competitive investment alternative.

Similarly, when money is flowing out of stocks and Treasuries are viewed as favorable alternatives, this demand for Treasuries causes the interest rates to fall.

Corporate Bonds are Awash in Good News

In the world of bonds, treasuries are considered about as safe as they come.

Because of their relatively lower risk Treasuries almost always have lower interest rates than do corporate bonds of similar terms. In recent months, however, corporate bonds have attracted so much demand that the interest rate on an average good quality corporate bond is only 1 to 1.5 percent higher than the rate on Treasuries. Compare this spread with early 2016, when the corporate bond vs. Treasury spread was closer to 2-3 percent.

As of late 2017, lower quality corporate bonds (“junk bonds”) are offering only about 3.5 to 4 percent more than Treasuries. Compare this with early 2016, when junk bonds were offering interest rates as high as 8 or 9 percentage points above equivalent Treasuries.

For you stock investors out there, these types of interest rate swings may not appear particularly significant, but bond interest rates, especially those of higher quality bonds, aren’t prone to fluctuate wildly over short periods of time. Trends are observed slowly and movements are tracked via fractions of percentage points.

Noting the difference of a half or a full percentage point on average interest rates over a given time interval is a significant observation and behooves us to consider the causes.

Good press for corporate bonds has been coming down the pipes at a steady clip, certainly contributing to their popularity. Talks of tax reform in Washington bode well for the corporate bond market, as companies with a reduced tax burden have a higher likelihood of paying off their debts in time and in full.

Meanwhile, the Fed’s continued avoidance of dramatic interest rate hikes keeps capital cheap and lowers the interest rates on Treasuries, making corporate bonds ever more attractive.

What Does it Mean for Your Portfolio? My Take

Everyone seems to be really digging corporate bonds these days, so you should too, right?

Wrong.

Remember, just because an investment is popular does not mean it’s right for your portfolio. In fact, popularity and hype may often have a distorting and even damaging effect on your returns.

When it comes to bonds, one thing you always have going for you is options. Not options as in the derivative securities, but options as in, quite literally, options.

Investors looking for a shorter-term play may want to shop through the corporate bond aftermarket—perhaps you can get your hands on some of those higher-interest 2016 bonds, though you will definitely pay a significant mark-up.

But who cares about the mark-up if corporate bonds continue be issued at lower and lower interest rates? You can enjoy the marginally higher coupon (interest) payments for a while and then sell the bonds off, ideally for a profit.

For retirees looking for a boost to their incomes, and other investors in search of yield, don’t neglect to consider lower-rated “junk” bonds. Especially in a lower interest rate environment, obtaining good yields often requires the acceptance of a little more risk. The graphic below will provide you with the classification indices used by the three main bond ratings bureaus.

Obviously, the lower the grade, the higher the risk and the higher the yield.

Click or tap to enlarge

Not all corporate bonds are created equal. The higher the risk, the higher the reward.

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This article is a part of our ongoing series that explores a different stock or fund each week. The information contained herein should not be construed as ‘financial advice’ and is presented as the opinion of the author.

ClydeBank Media does not offer financial investment services and has no ties to any of the funds presented in this list. Please see our full financial disclaimer regarding the information contained within this stock analysis. Always consult your financial adviser before making investment decisions.