Corporate bonds remain among the riskiest fixed-income assets, according to Ignacio Sosa, director of international relationship management at DoubleLine Capital in Los Angeles, Calif.
“There has been an enormous amount of issuance of corporate bonds since the financial crisis,” he said in an April 9 interview.
Since the U.S. Federal Reserve signalled a pause on interest rate hikes earlier this year, there’s been an influx of cash into corporate bond funds.
Roughly half of the investment-grade index of corporate bonds is at the lower end of the credit-rating spectrum, Sosa said. If the economy slows, leading to credit downgrades, a large number of corporate bonds could be downgraded to below investment grade.
Investment-grade corporates are sensitive to changes in interest rates, he explained. Central banks may be on pause right now, with the Fed, the Bank of Canada, and European Central Bank not signalling any rate hikes for the interim. However, Sosa noted that “if interest rates were to rise from the current, very low level, corporate bonds will likely be hurt. And since the spread over Treasury— the difference between the yield and the corresponding Treasury—is relatively tight, there is not a lot of cushion to absorb higher rates.”
As a result, he’s “very cautious” about the corporate bond market. “We think it contains some potential landmines.”
To avoid these landmines, Sosa suggested focusing on companies that have strong balance sheets and good cash flow. Companies with these fundamentals would be less likely to be downgraded in a slower economy. “And we think the likelihood of having a slower economy next year and beyond is a real possibility.”
Investors should also look to other fixed income assets, he said.
“Many investors think of corporate bonds as the only way [to] get exposure to credit assets,” he said, but there are other options that provide better potential returns.
For instance, Sosa likes emerging market dollar-denominated bonds, which are “much more attractive than investment-grade corporate bonds in the developed world that have similar duration.”
He also pointed to securitized assets, like mortgage- and asset-backed securities, which he said he also prefers, generally speaking, to corporate bonds. And he has a modest allocation to high-yield bonds but almost no investment-grade corporate exposure.
Sosa said his firm’s flexible yield strategy has performed well in various markets because it has low sensitivity to interest-rate increases, also known as duration risk.
“We try to have the yield of the strategy be higher than [the] duration because there’s no better protection against rising rates than having an attractive yield,” said Sosa, whose firm manages the Renaissance Flexible Yield Fund.
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