Stocks are falling again. Whether or not they’ll continue that, risk certainly remains. Investment grade bonds could offer decent return compared to safe bonds and potentially stocks.
And a note out from UBS Global Wealth Management broke down why.
First off, the S&P 500 has fallen 4.6% to start the week, with a loss on Tuesday as high as 3.3%. That comes as the index has rallied from its March 23 bear market low by 23%, sending earnings 2020 multiples soaring from below-normal levels historically to above. The market has looked past the coronavirus, as lockdowns potentially ease in May, a vaccine seems to be in the works and the rate of infection spread decelerates.
Many on Wall Street had been calling for a slight pullback and with analyst’s 2020 earnings estimates starting to fall meaningfully, valuations still remain stretched. And the rate at which the economy and earnings will emerge from their doldrums remains to be seen. Depressed oil prices aren’t helping either, as the U.S. has become a larger oil producer than it was in past..
For relatively risk-averse investors putting new money into markets, the knee-jerk reaction may be to buy up the 10-year treasury bond, which has indeed seen its yield slip to 0.57% as of Tuesday, before buying stocks for the long haul. Or investors can buy more stocks.
But investment grade bonds, as UBS points out, currently offer a deal rarely found in financial markets: a premium rate of return compared to bonds and maybe compared to stocks, without much added risk. Investment grade bonds are technically seen as risk assets. They are in the asset class of credit, where bonds are priced primarily based on the issuer's ability to repay, and secondarily based on expectations of future interest rates and inflation, all the while reflecting a slight risk premium over the latter.
But they seem to offer a buffer between risky stocks or high yield bonds and safe treasuries.
"With US and European equities already pricing an outcome between our central and upside scenarios, we are neutral on the broad equity indexes, and advocate being selective in the space,” wrote UBS’ Chief Investment Officer of Global Wealth Management, Mark Haefele in a note. "We see increasing exposure to investment grade credit as the best way to add risk assets to portfolios at this time.”
Haefele pointed out that investment grade bonds in the U.S. offer a 200-basis point spread over the 10-year treasury, or 2% more than the 10 year treasury bond does. That spread has a 2020 peak of 350 basis points. The iShares iBoxx Investment Grade Corporate Bond ETF LQD has risen 23% from its March 23 low, as the corporate credit outlook has improved, and as the Federal Reserve has provided stimulus in several forms, including by buying investment grade corporate bonds to keep borrowing costs for struggling companies low.
Still, Haefele says the spread could fall to 150 or 100 basis points by the end of the year (yields fall as prices rise). Even if the stock market is getting ahead of itself for now, credit conditions are still expected to improve by the end of the year as lockdowns ease and the Fed continues its pledge or supporting the economy with unlimited injections of liquidity.
And unlike stocks, Investment grade’s now have the benefit of a floor on price, as the Fed has begun buying these bonds.
Importantly, high yield bonds offer roughly 700 basis points over the 10-year treasury and have been enjoying Fed support of late, as the Fed has decided to include riskier more debt-laden companies in its bid to steer the economy away from depression.
Another risk to the investment grade bond thesis: stocks could drop in the near-term, but they could still very well end the year far higher than their current level.
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