The Worst Risk/Reward in History?

By Charlie Bilello

10 Jun 2020

The yield on investment grade corporate bonds has moved all the way down to 2.35%.

If the month ended today, that would be the lowest monthly close in history.

Note: throughout this post, we use the ICE BofA US Corporate Index as the investment grade bond proxy.

Why is this important?

Because the single best predictor of future returns for bonds are its starting yield. On average, the higher the starting yield, the higher the future return, and vice versa.

So with yields at all-time lows, one should expect future returns to be at all-time lows as well.

Let’s run through a few examples…

At the end of October in 2008, the yield on investment grade bonds was 9.23%, a record high. Over the next 9 years (their approximate duration), investment grade bonds would earn 8.1% per year.

By October 2009, one year later, the yield on investment grade bonds had fallen to 4.85%. Over the next 9 years, these bonds would earn 4.6% per year.

To be sure, the starting yield on bonds is only part of the equation. The direction of interest rates and credit spreads matter as well, particularly in the short run. But over time these other factors tend to be far less important than the starting yield.

Today, we have a combination of interest rates near all-time lows (10-Year Treasury Yield at 0.79%) and investment grade credit spreads (1.56%) well below levels typically seen during recessions.

The Federal Reserve has had a major influence on both of these factors in moving short-term interest rates back 0%, resuming its quantitative easing program, and buying corporate bonds for the first time ever.

The result was a vertical rally in investment grade corporate bonds ($LQD is largest investment grade corporate bond ETF) like we’ve never seen before.

Yes, interest rates and credit spreads could still move lower and such a move would certainly boost short-term returns. But for longer-term returns to improve from here, investors would need to see just the opposite.

The only path to higher long-term bond returns is short-term pain, with interest rates and/or credit spreads moving higher.

Corporate bond investors today are left with the prospect of little reward (2.35% yield) and higher risk (potential for rising rates/credit spreads).

Is this the worst risk/reward in history? I don’t know, but it’s right up there.

Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.

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