Now is a good time for investors to rebalance their fixed-income portfolios and add more government bonds.
As the stock market reaches new highs, I remain concerned that investors are too complacent about risks, such as escalating trade tensions with China, a likely slowing in earnings growth and the expectation that the Federal Reserve will keep hiking interest rates. The same risks have me uneasy about the health of the corporate bond market. I suggest investors consider making some adjustments to their fixed-income portfolios now.
The bond market has undergone a recent shift in the relative performance of corporate bonds and government bonds. Investment grade corporate bonds were poor performers relative to Treasuries in the first half of the year, but have done better lately. In bond market parlance, we say that corporate credit spreads have tightened (or the interest rate differential with Treasuries has narrowed). That is usually a sign that investors are more positive about the state of the economy and foresee lower risk in corporate debt.
I think this may be a short-lived phenomenon. Investors may now have an opportunity to rebalance their bond portfolios, taking some profits in investment grade corporates and adding that to Treasuries.
One advantage of this plan is that the yield on the 10-year Treasury has risen above 3%—which strikes me as a decent yield for government-backed securities. I don’t foresee longer-term Treasury yields rising much more from here (bond prices move inversely to interest rates), so it seems like a good time to add some duration to your portfolio.
Conversely, investment grade corporates look riskier. The Federal Reserve is poised to hike short-term rates a full percentage point over the next year, which stands to raise borrowing costs for firms. The past 10 years since the financial crisis has included a surge in investment grade corporate debt issuance and much of it has been sold to foreign buyers, who may have lower appetites going forward if the dollar weakens from current peak levels, which I expect.
Plus, corporate fundamentals may not support further tightening of credit spreads. Companies are highly indebted and generally have less cash to cover interest, despite the strong earnings and cash flow growth. In the next recession, liquidity could become an issue.
Bottom Line: I don’t think investors should look to the recent tightening in corporate credit spreads for reassurance that the economy isn’t poised to slow. In fact, I think current pricing may prove an opportunity for rebalancing into longer-term government bonds, which have provided higher yields recently.