Corporate Bonds Risks, Returns Vs. Equities, Treasuries

Originally Posted, 26 June 2024 – Corporate Bonds Risks, Returns Vs. Equities, Treasuries

Corporate bonds inhabit a space in the investment landscape that is somewhere between sovereign bonds, like U.S. Treasuries, and equities in terms of risk and returns. Investment-grade corporate bonds, such as those in the Bloomberg U.S. Corporate Bond Index, typically display high correlations with U.S. Treasuries on a day-to-day basis although those correlations can decline during periods of market stress such as the global financial crisis and the onset of the pandemic. The correlation between investment-grade corporate bonds and the S&P 500 tends to track that of U.S. Treasuries, but investment-grade bonds tend to correlate more positively (or less negatively) with the S&P 500 than U.S. Treasuries. (Figure 1). 

Figure 1: Investment grade bonds behave much like Treasuries with a dash of equities

Source: Bloomberg Professional (ES1, TY1, LUACTRUU), CME Economic Research Calculations – Past performance is not indicative of future results

By contrast, high-yield bonds, such as those in the Bloomberg U.S. High Yield Very Liquid Bond Index, usually correlate more strongly with U.S. equities than they do with U.S. Treasuries. This is especially true when the correlation between U.S. Treasuries and the S&P 500 is negative, as was the case for much of the period from 2008 to 2021. This has been less true during the past year now that the Treasury-equity correlation has flipped back into positive territory. Even so, high-yield bonds continue to show a strong, positive correlation to the S&P 500 (Figure 2). 

Figure 2: High yield bonds tend to correlate highly with equities

Source: Bloomberg Professional (ES1, LF98TRUU, TY1, BVLNTRUU), CME Economic Research Calculations – Past performance is not indicative of future results

Back to Basics: What Corporate Bonds and Stocks Are in Theory and Reality

Both equities and bonds are liabilities on the corporate balance sheet. The risks surrounding corporate cash flows are what binds the corporate bond and equity markets together. In accounting, the assets and liabilities of a corporation must equal one another. Among the liabilities of a corporation are bank loans, bonds and other kinds of corporate debt along with shareholders’ equity. Shareholders’ equity is what remains for the company’s owners after all other liabilities have been paid off.

In this sense both the equity and corporate bond markets could be compared to options markets. Equity investors get all of the upside of the value of a company with limited downside: a non-leveraged equity investor can’t lose more than their initial investment. As such, in this example, equities could be compared to call options on the value of a corporation with a strike price of zero and no certain expiry.

By contrast, a corporate bond holder has limited upside: if they hold their security to maturity, they will never earn more than the agreed upon coupons and principal payments, but they could get less if the corporation defaults and fails to make good its debt payments. Corporate bonds must compete for capital with sovereign bonds, but they lack the full faith and credit of an issuing government with its powers of taxation and authority over a currency-issuing central bank. Therefore, holding corporate bonds is akin to being long a sovereign bond plus being short a series put options on the value of a corporation where the expiry dates of those put options correspond to the expected payment dates of the coupons and principal on the bond.

For investment-grade bonds, which are issued by corporations seen as having the highest credit quality and therefore the least underlying volatility of cash flows, those short put options have relatively low values. Hence, the premium of investment-grade corporate bonds tends to be relatively modest and they most often behave a great deal more like U.S. Treasuries than equities. By contrast, for corporations with lower credit ratings, investors deem their cash flows to be much riskier, the short put options have greater value and therefore high yield bonds offer much higher yield premiums or spreads over U.S. Treasuries. The greater value of the implied short put option gives them a stronger correlation with the equity market. 

The Complex Economic Relationship Between Corporate Bonds and the Stock Market

Corporate bond and equity indices can, however, diverge at certain stages of the economic cycle and we may be entering such a period of divergence. During the late stages of the past three economic expansions, high-yield bond spreads widened even as equity markets continued to climb. Investors perceived more risk in the system than they had in the middle-phase of the expansion. Increased perception of risk means higher implied volatility which, in turn, means more expensive options. For the U.S. stock market, which is in its essence could be compared to a call option market, implied volatility on options and stock prices trended higher during the end stages of economic expansions. For corporate bond holders this worked in the opposite way: higher implied volatility caused put options to become more expensive and since the owners of corporate debt are short put options, this lowered the price and increased the corporate bond yield premium since the holders of those bonds are short puts.

In the later stages of the 1990s economic expansion from 1997 to 2000, implied volatility on S&P 500 options generally rose, as did the stock market. In parallel, corporate bond prices, especially in the high-yield market, were falling as spreads widened (Figures 3 and 4). Between early August 1998 and the S&P 500’s total return peak in August 2000, the Bloomberg High Yield Bond Index (which pre-dates the newer Very Liquid version) had a total return of -0.5% while the S&P returned +43%. 

Figure 3: Implied vol. on S&P options began rising more than three years before the 2000 peak

Source: Bloomberg Professional (SPX and VIX) – Past performance is not indicative of future results

Figure 4: High yield spreads over Treasuries began widening in late 1997 even as stocks rose

Source: Bloomberg Professional (SPX and LF98OAS) – Past performance is not indicative of future results

Something similar happened in the late stages of the 2003-2007 expansion, but in a more compressed fashion. Between February and October 2007, on the eve of the global financial crisis, implied volatility on stocks rose as corporate bond spreads widened (Figures 5 and 6). During this time the S&P 500 returned 9.7% while high yield bonds returned 1.7%. 

Figure 5: Implied vol. on S&P options began rising eight months before the October 2007 peak

Source: QuikStrike (ES_30_ATM Options),Bloomberg Professional (SPX and VIX pre-2007) – Past performance is not indicative of future results

Figure 6: High-yield bond spreads also began widening eight months before the 2007 peak

Source: Bloomberg Professional (SPX and LF98OAS) – Past performance is not indicative of future results

What this means is that had one attempted to hedge risk of a high-yield bond portfolio in the late stages of an economic expansion with equity index futures, one might have been exposed to significant losses. On the one hand, high yield corporate bond returns were close to zero as spreads widened out over Treasuries. On the other hand, equity prices continued to rise. This is why having a futures contract on corporate bonds could be so interesting for portfolio managers: the optionality inherent in corporate bonds and equities requires very specific hedging instruments. This is especially true in environments in which the prices of stocks and high-yield bonds might begin drifting in opposite directions. 

Are there downside risks to corporate bonds?

For the moment implied volatility and credit spreads remain near record low levels (Figures 7 and 8). This might mean that the equity market is nowhere even close to its ultimate top. Simultaneously, it also implies that investors in high-yield bonds might expect rather modest returns. In a scenario in which there is no further spread tightening, the most that a corporate bond investor could hope for would be equal to the return of the U.S. Treasury + a 3.1% yield premium. Of course, their returns could be better than that if high-yield spreads over Treasuries compress further. 

Figure 7: Implied volatility on S&P 500 options is near record lows

source: Bloomberg Professional (SPX and VIX) – Past performance is not indicative of future results

Figure 8: Historically narrow spreads imply limited upside, lots of downside on high yield bonds

Source: Bloomberg Professional (SPX and LF98OAS) – Past performance is not indicative of future results

However, there are major downside risks to corporate bonds: if spreads begin to widen as they did towards the latter stages of past economic expansions. As we saw during the late 1980s, late 1990s and in the run up to the global financial crisis (and to a lesser extent in the run up to the pandemic sell off in 2020), volatility and credit spreads widened well ahead of the peak in the equity markets. As such, if one wanted to hedge corporate bond exposure, it might be wiser to do so with futures on corporate bond indices rather than equity index futures.  

It’s also worth noting that our argument applies in reverse during the late stages of recessions. During the 2001-2002 tech wreck recession, implied volatility on equities and high-yield bond spreads over Treasuries peaked before stocks hit bottom. Likewise, during the global financial crisis the high-yield bond market hit bottom on December 12, 2008, whereas the equity market hit bottom nearly three month later on March 6, 2009. During this time the S&P 500 had a -24.8% return even as the Bloomberg High Yield Bond Index rose by 9.9%.

Historically, corporate bond spreads have closely tracked defaults on corporate bonds, which remain at very low levels currently.  As of the end of Q1 2024, about 1.1% of corporate debt payments were in arrears of more than 90 days (Figure 9). 

Figure 9: Corporate bond defaults remain at very low levels currently

Source: Bloomberg Professional (USEQCCTO and USDEBLBC) – Past performance is not indicative of future results

That’s the good news. However, default rates on credit card and auto loans are soaring. In 2006 and 2007 rising credit card and auto loan delinquency was a leading indicator in a later upturn in default rates on corporate debt as well as a widening of credit spreads. That occurred after the Federal Reserve (Fed) tightened policy by 425 basis points between June 2004 and June 2006. This time around, the Fed has raised rates by 525 bps. Given that the consequences of higher rates are already spreading through various consumer loan markets, it’s difficult to imagine that corporate bond market will be immune (Figures 10-12). 

Figure 10: Credit card and auto loan defaults are soaring and led the way in 2006-2007

Source: Bloomberg Professional (USDEBLBC, USEQCCTO, USEQTMTO and USEQTLTO) – Past performance is not indicative of future results

Figure 11: Are rising credit card loan defaults an indicator of future high-yield spread widening

Source: Bloomberg Professional (USEQCCTO and LF98OAS) – Past performance is not indicative of future results

Figure 12: Auto loan defaults were a leading indicator of spread widening in 2006-2007

Source: Bloomberg Professional (USEQTLTO and LF98OAS) – Past performance is not indicative of future results