Corporate bonds are trouncing stocks … Neil George doesn’t see inflation risk being a problem anytime soon … a focus on quality bypasses default fears … a fund to consider
The stock rally beginning after the March 23rd bottom has been nothing short of extraordinary.
Below, you can see the S&P 500 climbing 47% in a little over four months.
This spectacular rebound is what makes the following so awkward to write …
Stocks are getting outdone — by bonds.
This may come as a surprise to many readers. After all, most of us are taught that stocks are the high-fliers we add to our portfolios for growth, while bonds are the steadier, subdued income-play.
How times have changed …
Below, we compare the iShares iBoxx Investment Grade Corporate Bond ETF, LQD, with the S&P 500. As you can see, while the S&P has finally positive on the year (up 2%), LQD is up a shade under 10%.
Keep in mind, as we’ve noted in past Digests, the S&P has become incredibly tech-heavy with its skew toward the FAANGMs, which have been dominating stock returns.
If we remove this skew by looking at the S&P 500 Equal Weight Index, the discrepancy between stock and bond returns is even greater.
Below you’ll see LQD, with its near 10% return in 2020, towering over the S&P Equal Weight’s loss of 7.4%.
Given this substantial outperformance so far in 2020, is there still more juice left in bonds?
Today, let’s see what our income-investment expert, Neil George has to say.
As the editor of Profitable Investing, Neil specializes in finding his subscribers big income, whether through high-yielding dividend-stocks, bonds, REITs, MLPs, or more obscure investment vehicles.
In his newest issue, Neil makes the case for why he still likes bonds today — even after the trouncing they’ve given stocks in recent months.
So, what’s he looking at?
Let’s find out.
***”Bonds, a better bet”
That’s Neil’s conclusion when he compares bonds with the S&P 500.
From his most recent August issue:
Bonds in the U.S. continue to be a better bet in terms of safety, growth and income.
The overall aggregate bond market comprised of all bonds in the U.S. has returned 9.9% over the trailing year.
And for the year to date, the overall market has returned 7.4%. This is way better than even the tech-laden S&P 500’s return.
As to what’s behind this bond-outperformance (particularly the outperformance coming from corporate bonds), there’s a simple explanation — the Fed.
Back to Neil:
The Federal Reserve has a lot to do with the bond market’s favored returns. And unlike for stocks and consumer and business contributions to the economy, bonds are way less at risk for political football scraps.
The Fed will keep buying bonds for years to follow, much like it did after the 2007-2008 financial mess. And it will provide a backstop for cash and credit markets for the foreseeable future.
***But what about inflation?
Inflation is like kryptonite for bonds.
Today, given the trillions of new currency created by the Fed, there’s an easy case to be made that we’re setting the stage for massive inflation in the years to come. Plus, over the weekend, we learned that the Fed is weighing abandoning pre-emptive rate moves to curb inflation.
But inflation-concerns don’t worry Neil today. And as we’ve pointed out here in the Digest, while inflation is a major concern further out — our immediate concern is actually deflation if our economy continues to sputter.
Back to Neil’s issue:
Inflation is nowhere to be seen. Labor supplies will keep costs low, and commodities and energy will not be a problem.
The result is that the core Personal Consumption Expenditure (PCE), at a current rate of 1%, is nowhere near the mid-2% needed for the Fed to think about reversing course.
And with inflation so low, bonds remain bargains.
Neil notes that they’re yielding so little that their real yield (the nominal yield minus inflation) is negative. Even if you invest in a treasury bond that goes out 20 years, its real yield is still negative (and barely positive if you extend that to 30 years).
***But with the economy struggling to bounce back and businesses closing their doors, does a bond investor need to worry about defaults?
High-yield “junk” investors should be careful, but you’re on firmer ground with quality investment grade bonds.
Historically, top-quality bonds have very low default rates — even during the 2008/2009 economic crisis.
From MarketWatch:
The number of companies who defaulted on their debt reached a record high in 2009, more than doubling from 2008 as the recession weighed heavily on companies with below-investment grade ratings, according to Standard & Poor’s …
The speculative-grade corporate default rate in the U.S. was 11% at the end of 2009. The investment-grade default rate was 0.34% at the end of 2009, with only five companies defaulting. It was higher in 2008, at 0.73%.
So, even at the worst point in the financial crisis, quality investment grade bonds managed to keep defaults beneath 1%.
Perhaps the easiest head-to-head comparison of investment grade defaults versus junk defaults comes from the Corporate Finance Institute:
(To make sure we’re all on the same page, bonds with a rating of BBB- or better are considered “investment grade.” A rating lower than that places the bond into “junk” territory.)
Historically, investment-grade bonds witness a low default rate compared to non-investment grade bonds.
For example, S&P Global reported that the highest one-year default rate for AAA, AA, A, and BBB-rated bonds (investment-grade bonds) were 0%, 0.38%, 0.39%, and 1.02%, respectively.
It can be contrasted with the maximum one-year default rate for BB, B, and CCC/C-rated bonds (non-investment-grade bonds) of 4.22%, 13.84%, and 49.28%, respectively.
The takeaway is simple: if safety is more important to you than yield, stick with high-quality investment grade bonds.
***So, what corporate bond fund might you consider today?
In recent updates, Neil has recommended investors look at the Vanguard Intermediate-Term Corporate Bond ETF (VCIT).
The fund invests primarily in investment-grade bonds with an average maturity of between five to 10 years.
Below, you can VCIT climbing 7.6% here in 2020, which inversely mirrors the S&P Equal Weight’s 7.4% decline.
As to income, VCIT offers a 2.9% yield as I write. That’s well above the S&P 500’s dividend yield of 1.81%.
This is just one of the bond funds Neil likes. For more of his income ideas, click here.
Here’s Neil with the final word:
Less risk from inflation, less risk from politics and the Fed backstop means bonds continue to make for a safer source of growth and income.
Have a good evening,
Jeff Remsburg
