Understanding the Performance of Corporate Bonds
Three factors that drive the returns of corporate bonds
Corporate bonds can be a source of compelling opportunities for many investors since they typically offer more significant yields than those available on U.S. Treasuries. The reason for this is simple: Since corporations are viewed as more likely than the government to default on the payment of interest or principal, they must compensate investors with higher yields to attract attention.
As a result, many fixed-income investors hold corporate bonds through either mutual funds or within exchange-traded funds. But what are the drivers of corporate bonds’ performance—and by extension, the value of investors’ portfolios—on a day-to-day basis?
Three factors stand out as the most important for bond performance.
Prevailing Interest Rates
Since corporate bonds are priced on the yield advantage they provide relative to U.S. Treasuries (also called yield spread or yield advantage), movements in government bond yields directly impact the yields of corporate issues.
To illustrate, if Acme Corp. issues a bond at 5% when the 10-year Treasury is at 3%, there is a yield advantage of one percentage point. Since bond interest rates are in theory tied to the 10-year Treasury rate, if the yield on the Treasury falls to 2.5%, the corporate bond yield will fall to 4.5% (all else being equal). Keep in mind, prices and yields move in opposite directions.
The chart below demonstrates the 10-year Treasury constant maturity rate vs. Moody's seasoned AAA corporate bond yield.
The Financial Health of the Issuing Corporation
The higher the risk of an underlying security, the higher the yield it will typically have. As a result, the changes in a company’s financial health will affect its corporate debt prices.
For example, if Acme Corp. reports record profits and shows an increased amount of cash on its balance sheet, investors would feel more comfortable owning that bond. They wouldn't require as high a yield to hold it in their portfolios. The result is falling bond yields and rising prices as investors become comfortable.
Conversely, a business slowdown causes another company to report a loss in a quarter. Investors, concerned that the company will need to burn through cash to maintain its operations, grow more worried about its financial health—its bond prices drop and yields increase.
This development would cause the company’s stock price to fall, lowering their bond prices and raising the yields.
Corporate bonds also receive credit ratings from major agencies such as Standard & Poor's or Dunn & Bradstreet based on their financial health and ability to pay their debts. The agencies can upgrade or downgrade a company’s rating, which typically causes the company’s bond prices to react when new ratings are released.
Investors’ Overall Perception of Risk in the Global Markets
Corporate bonds’ performance is sometimes affected by issues having nothing to do with the companies but rather investors’ view of the broader investment environment.
When the headlines regarding the market are positive, investors grow more comfortable looking for opportunities in higher-risk investments. High optimism typically causes money to flow out of Treasuries and other “safe havens” and into investments that offer higher yields, such as corporate bonds.
When global or economic circumstances begin pointing towards a downward trend in prices, investors typically sell some or all of their investments in riskier market segments (including corporate bonds) and flee to the safety of U.S. Treasuries.
In part, investor sentiment can drive interest rates. When disruptive events in the global economy occur, investors become more averse to holding anything seen as being higher-risk in nature. On such occasions, lower-quality corporate issues are typically hit the hardest relative to their higher-quality counterparts.
Putting It All Together
It’s important to keep in mind that all three factors are at work simultaneously more often than not. This is particularly true for a corporate bond mutual fund or ETF, where the impact of changes in a single company's underlying financial strength is difficult to discern.
Still, understanding these three issues can provide a better appreciation of the factors that drive the performance of corporate bonds.