Investment-Grade Corporate Bonds Are Offering Real Income. That's Not Why You Should Be Nervous.

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Your client needs income. They're retired, or semi-retired. They have a pile of money, and they want it to work for them while they sleep. They're tired of the U.S. Treasuries that pay nothing. They're tired of the money market funds trying to keep interest rates artificially low. They need income — real income.

Investment-grade corporate bonds are offering it in the form of yields above 5%. That's a compelling number, and you're thinking about how to position this client's portfolio.

Here's the problem: That 5% shouldn't be possible right now.

In normal markets, you get one or the other. You get high yields with cheap prices because the market is nervous about the future. Or you get expensive prices and low yields because the market is confident in the economy and the direction of the markets.

Right now, you get both. And that's what should worry you.

What's Actually Happening

Let's talk about this without the jargon. Your client is looking at a corporate bond that pays 5% per year. What does that mean?

A Treasury note pays 4%. That's solid, safe income. Investment-grade corporate bonds pay 5.5% or 5.75%. That's 50 basis points more than the bond under consideration. Corporate bonds pay an extra yield because you're putting your money in a company that might go through rough economic times. A company can fail. That's the risk.

The spread between corporates and Treasury notes is known as the credit spread. When it's tight, the market is essentially saying that corporate bonds are just as safe as Treasuries. When it's wide open, the market is nervous about the corporations in question and paying more for the risk.

Right now, credit spreads on investment-grade corporate bonds are the tightest they've been in 20 years. That means the market thinks the credit quality of these companies is not worth worrying about. The base interest rate on corporate bonds is high, too: 5%+. That's what makes the yields so attractive.

Prices have been bid up to expensive levels because of this combination. This means that the price of these bonds is exposed to market risk. Any movement in interest rates will hurt the corporate bond prices.

The Tension

That's why it's so difficult for advisors. It's not in the job description. It's not expected. But it's a problem in the real world.

Your client wanted income of 5% per year. After doing the math, they can see how that income will pay for their groceries, their trips, and their other expenses.

But they haven't considered that the price at which they have to buy these bonds leaves no margin for error. If interest rates go up even a half percentage point or if corporate credit spreads widen even a quarter of a percentage point, the value of their corporate bond portfolio will drop.

Let's do the math.

Assume the client puts $100,000 into a corporate bond portfolio that pays 5%. Six months later, after all is well and the markets are stable, the Fed announces that it'll be sticking with the current interest rates for the foreseeable future. That's one-quarter of a percentage point of widening corporate credit spreads.

The value of the $100,000 corporate bond portfolio is now $93,000 or $94,000. That's a $6,000 to $7,000 loss in market value.

Their interest income for six months was $2,500.

That's a $4,000 loss in value for the portfolio over the six months.

That's what their statement will read. A loss.

They'll look at the advisor and ask, "Why am I down 6%?"

At the time of purchase, the advisor bought these corporate bonds at a valuation based on the assumption of continued optimism in the markets. Then the market changed its mind. Nothing happened in the investor’s life to cause a loss of income from these corporate bonds. But the market value of their portfolio dropped. That's what matters to the investor.

The Advisor's Real Problem

You know that spreads between corporate bonds and Treasuries are tight right now. You know what that means about credit quality and market perception. You know this dynamic won't last forever. Your client doesn't understand any of it. They just want the income. They've been sitting on cash for three years, and they're tired of waiting.

That's the tension between what you know and what they know. That's why the conversation matters.

What This Actually Means

There are two different cases for investors in corporate bonds right now.

Case 1 is when income is the focus. Your client just needs that income. They have the resources or the time to hold the corporate bonds until they mature. That will give them the 5% yield they're seeking. That's great news for them. They don't care if corporate bonds are trading at 94 cents on the dollar next year because they're holding them to maturity anyway.

Case 2 is when market valuation is an issue. Your client may need access to that money. They might need to take a trip. They might need to help a family member. The market is nervous, and they might have to sell their corporate bonds in the future. In this case, market valuations of corporate bonds that pay 5%+ are a cause for concern.

Most clients show up with a desire for income from corporate bonds and think they're Case 1 investors. However, they're actually Case 2 investors.

The Client Conversation You Need to Have

Before you buy a portfolio of corporate bonds for your client, have a conversation about this.

The income from corporate bonds is real, and 5% is legitimate. But I need to be honest with you about valuations. Corporate bonds are expensive right now. Spreads are some of the tightest in 20 years, which means the market isn't pricing in much risk. If that changes, if rates go up or credit spreads widen, these bonds will drop in value. Are you okay with that?

Let your client think about that.

Then continue:

I need to know you're okay with this even if life happens — if you lose your job, if something happens with family, or if you need money for something unexpected. These bonds won't bounce back overnight. You'd be selling them into a loss. Can you live with that?

If they say yes to both questions, and they mean it, then buy the corporate bonds. You've got an income investor on your hands.

If they hedge or look uncomfortable, don't buy the bonds. You're not selling an income investment. You're selling a speculation on whether or not interest rates and corporate credit spreads remain stable. That's a different conversation — and one you should not be having with them if they asked for corporate bonds.

The Bottom Line

Corporate bonds are offering real income, and 5%+ is very high for an income investor. But that income is only for investors who are willing to hold the corporate bonds until they mature. Corporate bonds are being valued very high in the market right now, and any disappointment in the market for corporate bonds or credit risk will hurt those corporate bond prices.

The market is efficient enough that such high yields on corporate bonds and expensive valuations are not given out freely. There has to be some reason, some thing that is being priced into the market now. Your job as an advisor is to make sure your clients understand what that thing is before they hand you their hard-earned money.

Get that part of the job right, and you'll sleep well at night. Get it wrong, and you'll be explaining losses on their income portfolio to a very unhappy client for the next year.

Charles Urquhart, CFA, is the founder of Fixed Income Resources and an adjunct professor of fixed income at Loyola University Maryland’s Sellinger School of Business. He spent 30 years on institutional fixed income trading desks including Lehman Brothers, Fidelity Investments, and Tradeweb.

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