Can the Rally in Corporate Bonds Continue?

It can, but don't fall asleep at the switch

By Daniel Putnam, InvestorPlace Contributor

Forget stocks — the real action these days is in corporate bonds. Since June 6, the iShares iBoxx $ InvesTop Investment Grade Corporate Bond Fund (NYSE:LQD) has gained 4.5% — which in the bond world is nothing short of blistering.

The strength in corporate bonds is nothing new. Through June 30, the Barclays Corporate Investment Grade Index had generated an average annual total return of 7.46% in the trailing five-year period, walloping the -0.92 return of the S&P 500 Index. Corporates also are ahead in the 10-year period, returning 6.56% annually versus 4.13% for the S&P. In fact, during the past 10 years an investor would have been better off investing in corporates than large caps, small caps, developed-market international stocks or commodities.

Corporate bonds have benefited from a nearly perfect investment environment in recent  years. Corporate performance has been excellent. Businesses found religion in the wake of the financial crisis, prompting them to reducing debt, cut costs and improve their balance sheets. The result has been a pronounced decline in investors’ perception of credit risk, which has provided a persistent bid for corporates and caused yield spreads to fall. At the same time as corporate health has been improving, sluggish economic performance has led to a sharp decline in interest rates.

Put these two together — declining absolute yields and a declining risk premium — and you have the recipe for strong performance.

What’s Next?

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The question now, of course, is whether the rally can continue.

The first factor investors look to when assessing corporates is their yield spread over Treasuries, and on this front the asset class continues to look reasonably priced. The chart to the right shows that corporates’ yield spread, despite having fallen substantially this year amid investors’ ongoing thirst for yield, still is above average and more than double its level of the 2004-07 period. It’s unlikely the spread will get back to that level anytime soon given the ongoing macroeconomic risks, but it shows that corporates still have room to run.

There is a flip side to this, however. The tighter the spread gets, the more vulnerable corporates are to a spike in Treasury yields. Indeed, one of the few periods of poor performance corporate bonds have suffered in 2012 accompanied the explosive rise in government bond yields that occurred during March. Investors therefore need to be acutely aware that an investment in corporates remains a bet on Treasury yields. And Treasuries won’t remain a one-way market indefinitely.

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The other issue to consider is that corporates are in extreme overbought territory right now. The relative strength index (RSI) on LQD has reached its highest level ever, and its absolute yield is at an all-time low. In addition, the ETF is 6.6% above its 200-day moving average, which is high on the upper end of the historical range. Investors therefore need to employ an element of caution, since the asset class looks ripe for a short-term pause.

For now, the key factors that have fueled the rally in corporates remain in place: improving corporate performance, a low-yield environment, and strong inflows into mutual funds and ETFs. Nevertheless, investors would be wise not to fall asleep at the switch with regard to the risks — especially with the asset class having rallied so strongly in the past two months.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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