Investors are demonstrating caution midway through 2018 by taking steps to help insulate their portfolios. Thats understandable on the heels of a nine-year bull market in U.S. stocks, given renewed volatility, uncertainty surrounding global trade policies and steadily rising interest rates.
Rather than sit idle in cash, investment grade corporate bonds may offer a mix of stability and income to investors seeking to navigate the current market environment. Investment grade corporate bonds represent something of a middle ground for investors between riskier equities and perceived safe haven assets like Treasury bonds.
For one thing, investment grade corporate bonds are generally less volatile than the broad equity market. Over the past three years, the total return volatility for U.S. investment grade corporate bonds has been roughly 3.4%, compared with total return volatility near 10% for U.S. stocks.
Investment grade bonds are typically issued by high-quality corporations, those with credit ratings between AAA to BBB-. Since corporate bonds carry credit risk, or the potential for default, they tend to offer a higher yield than similar maturity government bonds.
A sweet spot for yields
With the U.S. economy on surer footing, the Federal Reserve has ratcheted up its target short-term interest rate three times over the past year. Markets are pricing in at least one more increase before the end of 2018.
In turn, investors are demanding higher yields on corporate bonds. Longer-maturity investment grade corporate bond yields have increased between 0.4% and 0.8% over the past year, as the chart shows; short-term corporate bond yields are up more than 1.25% in yield over the past year.
Using corporate bond ETFs to manage investment goals
Investors should think about their investment goals and time horizon when weighing the merits of investment grade corporate bonds. Dividing the corporate bond yield curve into distinct maturity segments, such as 1-5 years or 5-10 years, allows investors to target specific corporate bond maturity profiles depending on their needs, risk tolerance and investing horizons. Exchange traded funds (ETFs) allow investors to assemble customized investment grade corporate bond portfolios.
How to think about bond maturity ranges:
1 to 5 years: This range may suit investors who want to reduce vulnerability to the risk of rising interest rates. With corporate bond index yields in this maturity range currently hovering over 3%, investor cash flows may help keep pace with inflation, which in June rose 2.9% from a year earlier. This is good news for savers who seek to preserve the purchasing power.
5 to 10 years: This range may reward investors with higher yields but comes with incrementally higher interest rate risk. Known as the belly of the yield curve, the 5-10 year maturity range generally offers higher income with an intermediate duration of about 7 years.
10+ years: This range may suit investors aiming to diversify their equity portfolios and are comfortable with interest rate risk. Long-maturity corporate bonds can add diversification because interest rate risk tends to be negatively correlated to the stock market. In times of market stress, stocks tend to fall and higher quality bond prices tend to rise as investors seek perceived safe haven assets. With yields generally higher than bonds with maturities less than 10 years, longer-maturity bonds may serve dual purposes of boosting income and potentially hedging the equity allocation of their portfolios.
Broad: Owning bonds of all maturities in a broad index may be worth considering for investors wanting a more general allocation to corporate bonds but without a specific view on the yield curve. Investment grade corporate bonds comprise about one-third of the total U.S. bond market and can serve an important role in portfolios.
Consider using a low-cost bond index ETF to invest in the corporate bond markets.
Maturity Range Investor Objectives Index Yield Index Duration Related iShares Bond ETF Related ETF Expense Ratio
- 1-5 Years Seek to keep pace with inflation or shorten portfolio duration 3.49% 2.8 iShares Short-Term Corporate Bond ETF (IGSB) 0.06%
- 5-10 Years Seek income or express a view on the belly of the yield curve 4.16% 6.3 iShares Intermediate-Term Corporate Bond ETF (IGIB) 0.06%
- 10+ Years Seek income or help diversify against equity market risk 4.67% 13.6 iShares Long-Term Corporate Bond ETF (IGLB) 0.06%
- Broad: Entire Curve Seek increased income relative to government bonds, help diversify against equity market risk 4.04% 7.1 iShares Broad USD Investment Grade Corporate Bond ETF (USIG) 0.06%
Source: BlackRock and ICE BofAML as of 7/30/18. 1-5 year maturity range represented by the ICE BofAML 1-5 Year US Corporate Index, 5-10 year maturity range represented by the ICE BofAML 5-10 Year US Corporate Index, 10+Year maturity range represented by the ICE BofAML 10+ Year US Corporate Index and entire curve represented by the ICE BofAML US Corporate Index. Index duration is the weighted average of the effective duration, which is a measure of interest rate sensitivity, of the bonds in the index as provided by the index provider. The related iShares Bond ETF seeks to the track the indexes shown. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
Karen Schenone, CFA, is a Fixed Income Product Strategist within BlackRocks Global Fixed Income Group.