Yields on corporate bonds have fallen so low that companies are rushing to issue as much new, longer-term debt as possible to lock in low rates. Does that mean investors should be buying?
According to a recent article in the Wall St. Journal, titled "As Corporate-Bond Yields Sink, Risks for Investors Rise," some caution may be in order. Consider this quote from the article: "Companies sold $75 billion of investment-grade corporate bonds in the U.S. last month, the busiest July ever for such sales, and the total for 2012 is on track to hit $1 trillion, according to ThomsonReuters. Corporate bonds sold last month pay an average interest rate of about 3.2%, an all-time low. Over the past 30 years, interest rates on those bonds averaged about 7.2%."
Despite the low yields, investors continue to gobble up long-term corporates in their ongoing search for investments that offer an alternative to the low rates on U.S. Treasuries. So far, this strategy has worked: in the one- and two-year periods ended September 4, 2012, the Vanguard Long-Term Corporate Bond exchange-traded fund (ticker:VCLT) has posted total returns of 15.2% and 25.6%, respectively. Still, investors should be mindful of the high level of interest rate risk in this segment of the market. If rates on longer-term Treasuries rise, longer-term corporates will be hammered. The resulting principal losses would more than offset the yield advantage.
While there is nothing on the horizon to suggest that long-term rates are indeed going to rise - inflation remains tame and the Federal Reserve is on the verge of announcing its intention to keep rates low through mid-2015 - investors need to be aware that the strong recent performance of corporate bonds comes with a hidden danger.