Why now could be a good time to buy corporate bonds

How have corporate bonds in the eurozone reacted during the first six months of this year? What factors influenced the prices and yields? What is their role and importance in a greatly diversified portfolio? Let’s quickly review what happened to this exciting submarket in the first half year – and then take a brief look at what may lie ahead.

Phase 1: The calm before the storm

Early this year, many European fixed-income investors were searching for investments providing a good return. The loose monetary policy pursued by the European Central Bank (ECB) had resulted in low yields for government bonds. In addition to the central bank, the prospect of moderate economic growth with comparatively low default rates and the purchase of corporate bonds by the ECB in this sector resulted in high prices and low yields. Some investors seeking greater performance therefore migrated to more risky sectors and pursued high-yield bonds from companies with lower credit ratings.

Past performance is not indicative for future returns.
Sources: Bloomberg Finance L.P., DWS Investment GmbH, as of: 07/01/2020

Phase 2: The COVID-19 shock

The situation changed abruptly with the rapid spread of the COVID-19 disease in Europe. It now became clear that the pandemic was spreading rapidly around the globe and that it would have a devastating effect on the economy. Growth forecasts for nations and regions were revised as quickly as the earnings forecasts for companies – both being key indicators for valuation in the equity and bond markets.

As a result of this increased uncertainty, the prices of not only stocks but also corporate bonds fell. Conversely, returns grew due to the greater risk of default. The strong fluctuations sometimes temporarily dried up the market. At times, it was nearly impossible to find a buyer for some bonds. Especially those bonds issued by companies in cyclical sectors suffered greatly because their development is closely linked to the economy as a whole. Overall, the spreads for corporate bonds in comparison to less risky government bonds grew substantially. Of the 15 days with the biggest increases in spreads on record, five days were in March 2020.

Phase 3: Central banks and governments take action

Help was on its way, however. Not only in the form of the gradually-developing economic stimulus programs being pursued by various governments and the EU Commission, but also in the Pandemic Emergency Purchase Programme (PEPP) announced by the ECB on March 18, which encompassed 750 billion Euros for bond purchases. The U.S. Federal Reserve took similar steps, giving the global bond markets the greatly needed liquidity and driving a shift in the second quarter.

Past performance is not indicative for future returns. Risk profiles of the compared asset classes differ.
As of: 30 June 2020; source: Refinitiv Eikon, in local currencies

Phase 4: A positive tone by midyear

In April 2020, eurozone companies issued a record volume of bonds worth 66 billion Euros to strengthen their liquidity. On the other hand, the creditworthiness of many companies suffered so greatly that the S&P rating agency lowered the valuations of over 1800 companies worldwide due to the pandemic. While this affected U.S. companies in particular, investment grade Euro-denominated bonds had fallen by approximately three percent of the overall outstanding volume in the period leading up to mid-June.

However, corporate bonds continued to gain late in the second quarter. The optimistic view that the COVID-19 lockdown wouldn’t prove as harmful as originally expected was initially evident in equity market and then the bond markets as well. There, the ECB provided an extra boost when it expanded the PEPP bond purchase program by an additional EUR 600 billion in early June, bringing the total to 1.35 trillion Euros. The iBoxx Euro Corporates index, which reflects the market for investment grade, Euro-denominated corporate bonds, on June 30 foresaw a negative performance of merely 0.5 percent for the first half year in 2020 — a hopeful conclusion to six unsettling months.

Perspectives for corporate bonds

What is the outlook for Euro-denominated corporate bonds? That depends greatly on the current pandemic. Analysts currently expect the eurozone economy to begin growing again in the third quarter already. That boosts hopes that the risk of corporate defaults will at least remain stable. The European Central Bank also played a key role, by announcing that it intended to continue its loose monetary policy. Eurozone government bond yields should therefore remain low enough to make corporate bonds attractive as a higher-yielding alternative.

Remaining uncertainties

Risks remain, however. A COVID-19 resurgence, in particular, would have a detrimental effect on corporate bonds — causing yields to rise and prices to thereby fall. In addition, there’s no consensus yet on the European reconstruction fund or the terms of the Brexit. A decisive factor will be the measures implemented by the ECB and other central banks to support the market. Investors appear to be setting their hopes on these factors: Capital inflows to corporate bonds with higher ratings almost reached the prior-year level in early June. And there are good reasons for this. Developments during previous months have shown that although corporate bond rates experienced stronger fluctuations than government bonds, investors were compensated for this higher risk through higher yields.

Choosing the right bonds and having the right timing both require extensive knowledge and experience. These are all good reasons for allowing a professional fund manager to actively handle the analysis and specific investment decisions, one who specializes in this asset class. Even if the prospects are good, remember that corporate bonds are subject to risks ranging from price decline to total loss if the borrower can no longer repay the debt - and this applies to bonds with a good credit rating as well.