When the next recession hits, default rates for bonds are likely to be significantly lower than they were in the financial crisis.
That’s no reason for advisors and bond investors to fell complacent, however. While the 23% rise in the S&P 500 captured the attention of the public in 2019, “it has been a great year for fixed income, particularly credit,” noted Mark Vaselkiv, chief investment officer of fixed income at T. Rowe Price.
Strong gains could set fixed-income investors up for some serious risks in the next 12 months, he continued. If 10-year Treasury yields back up modestly to the 2.25% area, the spillover effects in other “quality” sectors might be painful.
It may have been a stellar year, but performance across different bond markets was widely dispersed. Emerging markets, investment-grade corporates and high-yield bonds all enjoyed double-digit gains in the first 10 months of 2019, Vaselkiv said. But mortgage-backed securities and asset-backed securities returned less than 6%.
High-yield bonds were an area where the performance gap was particularly wide. Bonds in the two top-quality sectors of junk, Ba- and B-rated securities, managed to return 13.53% and 12.10% respectively.
However, bonds rated Caa or lower provided investment returns of 6.2% or less. This disparity raises a number of questions about the junkiest part of the sector.
Vaselkiv asked aloud if investors should be looking at beaten-down energy and automobile bonds but left the question open. Others have noted that the energy lenders have stopped providing easy credit of leveraged fracking concerns, so there may eventually be opportunities in that universe.
Some high-yield issuers got religion in last year’s fourth quarter when the junk-bond market dried up, and Vaselkiv said that credit quality in general had improved. As evidence of this trend, he cited the slowdown in the number of “crazy” private equity leveraged buyouts. Perhaps they are realizing that in the next downturn the markets “will be unforgiving for fragile businesses.”