Why investment-grade corporates make sense even as rates move lower

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.

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      By Bernard Scozzafava, CFADirector of Investment Grade Fixed Income Quantitative Research, Eaton Vance Management

      Boston - A flatter U.S. Treasury curve has reduced the yield advantage that intermediate investment-grade (IG) corporate bonds enjoy over bank deposit rates and prompted some investors to wonder whether certificates of deposit (CDs) may now be the better option. For long-term investors, we believe IG corporate bonds are still a more attractive investment. With interest-rate cuts on the horizon, allocating to IG corporate bonds can potentially allow investors to lock in attractive yields while limiting downside risk.

      CDs and IG corporate bonds are both high-quality investment options. When cash is needed for near-term expenses like a down payment or college tuition, CDs may be the best option. For investors with longer horizons, IG corporates can produce more income than currently available with CDs. And this long-term yield advantage may well continue as the Federal Reserve (the Fed) enters its next potential rate-cut cycle.

      It is important to note that even in a flat yield-curve environment, IG corporate bonds have historically out-yielded CDs. As shown in the chart below, CD rates have been closely tied to the federal funds rate, while IG corporate yields have often tracked at considerably higher levels. In fact, during periods of Fed rate cuts, shown in the shaded areas of the chart, the yield difference between three-month CDs and IG corporate bonds is the most pronounced. While no one can say with certainty when - or if - the Fed will cut rates, it appears that we are entering such a period. The markets are pricing in a 100% chance of a Fed rate cut in 2019, and some strategist are forecasting that the Fed may even reduce rates by 50 basis point at their upcoming July meeting.


      Past performance is no guarantee of future results. Yield information is based on the ICE BofAML 1-10 Year US Corporate Index, anunmanaged index that measures the performance of investment-grade intermediatecorporate securities

      In easing cycles, corporates offer advantages

      From a historical perspective, during rate-cutting periods, CD yields have declined much faster than corporate-bond yields.And due to their shorter maturity, three- month CDs expose an investor to greater reinvestment risk than IG corporate bonds. And although IG corporate yields have come down recently to just under 3%, they are still at levels generally not seen since 2011. Supply-demand dynamics should continue to support the market with demand, as measured by year-to-date mutual fund flows, double 2018 levels and net new issuance declining by 30%.

      Uncertainty remains a constant

      One reason the flatness of the yield curve has been getting so much attention is that an inverted yield curve has preceded each of the last five recessions and is a late-cycle indicator. But as we mentioned in our March blog post, "Does the yield curve really predict recessions?," today's markets are reminiscent of the mid-1990s. In 1994, the Fed was raising rates, which caused the yield curve to flatten but not invert. The following year, core inflation came in below target and the Fed reversed course and began to cut rates, which helped to extend the economic expansion. This comparison is getting much more attention in the press, as the Fed is widely expected to cut rates by September. In a July 10 statement, Fed Chairman Jerome Powell said that although he expects U.S. economic growth to remain solid and labor markets to stay strong, uncertainties persist and that the Fed is prepared to act. Downside risks to the U.S. economy include weakness overseas, Brexit uncertainty and unresolved U.S.-China trade policies.

      While we don't see a recession on the horizon, we do believe that we are in the later stages of the economic cycle. The current economic expansion is in its tenth year, the longest on record. Under these conditions, and in view of the likelihood of Fed rate cuts, we believe IG corporate bonds remain attractive.

      Bottom line: In recent weeks, the Fed has again signaled its willingness to trim interest rates as weakness overseas and other factors weigh on the U.S. economy. Historically, IG corporate bonds have offered higher yields and potentially more long-term income than CDs during rate-cutting periods. They also may be a good diversifier to equities as volatility increases.

      This discussion includes comparisons of different fixed-income instruments. Fixed-income securities carry inflation risk, liquidity risk, call risk and credit and default risk. Unlike bonds, CDs offer a fixed rate of return. Interest and principal on CDs generally are insured by the FDIC up to $250,000. FDIC insurance does not cover market losses.

      Investing entails risk including the risk of loss. In general, the bond market is volatile. As interest rates rise, the value of certain income investments is likely to decline. Investments in debt instruments may be affected by changes in the creditworthiness of the issuer and are subject to the risk of non-payment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments.