The credit crisis and related market turbulence has dramatically reshaped the fixed-income investment environment.
An unrelenting appetite for risk in recent years meant investors were willing to take on additional risk with little additional yield as compensation. As a result, the difference in yield between corporate bonds and virtually risk-free U.S. Treasuries with a comparable maturity date (also known as a credit spread) shrank to an abnormally slim margin.
But with the onset of the financial crisis, investors reversed course to a near-total aversion to risk. As they sought haven in the highest quality securities, yields of corporate bonds soared—causing prices of corporate bonds to plummet.
Fast Forward to Today
A phased recovery appears to be underway in the fixed-income market, with three key factors at work:
- The flight to quality in fixed-income markets is slowing as investors have become more comfortable taking on risk.
- Issuance of corporate bonds is booming after nearly grinding to a halt last year.
- Signs of recovery and government intervention are helping sectors of the fixed-income markets return to good health.
The intricacies of fixed-income markets have always offered opportunities for skilled active managers to add value. However, the current chaotic market conditions may have created even more opportunities for active management strategies to identify mispriced securities.
Although important risks remain, these shifts have created significant opportunities for investors willing to move beyond the safety of U.S. Treasuries—both to diversify their fixed-income portfolios and to pursue more attractive returns.
Credit spreads have been falling this year yet remain relatively wide. Because prices and yields generally move in opposite directions, a narrower yield spread indicates a higher price—and potentially higher total return for corporate bonds compared to other investment options. (Total return is the coupon income from a bond plus the change in its market price over the holding period.)
High-yield corporate bonds may offer even more rewards, but they also involve significantly more default risk. Given that we expect overall default rates to rise later in 2009, rigorous credit analysis essential. And in this ever-changing market, active trading and the ability to be nimble when opportunities arise is key as well.
Investment in mutual funds involves risk, including possible loss of principal invested.
Bond funds are subject to issuer default risk and interest rate risk, the risk that changes in interest rates will adversely affect the value of an investor’s securities. When interest rates rise, the value of fixed-income securities will generally fall. Conversely, a drop in interest rates will generally cause an increase in the value of fixed-income securities.
Investments in junk bonds can involve a substantial risk of loss. Junk bonds are considered to be speculative with respect to the issuer’s ability to pay interest and principal. These securities, which are rated below investment grade, have very high credit risk and a significant risk of issuer default, are subject to greater price volatility, and may be illiquid.