If we take the Fed at its word, interest rates–both short and long term–are likely to remain low for a very long time. While an improving economy and avoidance of the fiscal cliff would allow for some back-up in rates, it may be a long-time before we see a 3% yield on the 10-year yield again, let alone the historic average of 6.2%.
In the interim, yield-hungry investors are faced with a stark choice: accept lower yield or more risk. For those willing to take on marginal risk, we’ve long argued that investors could focus on equity income and fixed income credit risk rather than fixed income duration risk. On the credit side, we continue to believe that both high yield and investment grade bonds may offer good alternatives for investors looking for incremental income.
Credit spreads for investment grade bonds–particularly the lower end of the spectrum–still look attractive. Investment-grade debt has recently exhibited a higher yield premium than was historically the case. In addition, while investment grade bonds are offering a much higher yield than Treasuries, in our view, the default risk on corporate debt remains low.
Despite the slow growth economy, corporate balance sheets remain exemplary with large US companies holding over $2 trillion in cash. As such, we would remain overweight on the iShares IBoxx Investment Grade Corporate Bond Fund (NYSEArca: LQD), and for investors looking for more targeted positions, we would suggest looking at the iShares Baa – Ba Rated Corporate Bond Fund (NYSEArca: QLTB).
As for high yield bonds, spreads have tightened considerably since the spring. While investment grade spreads have also narrowed, the drop has been far less pronounced. While high yield spreads are now close to their historic average, and seem in line with what you’d expect given the economic climate, investment grade spreads are still wide relative to history.