Investors interested in buying corporate bonds may find it best to follow this strategy

Published Wed, Jul 13 20223:56 PM EDTUpdated Wed, Jul 13 20225:07 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

Investors lured by higher yielding corporate debt should expect more market turbulence, and they should proceed with caution, market pros warn. The corporate debt market has felt the double wallop of higher interest rates and economic uncertainty. In the month of June, global credit suffered its sharpest pullback since the pandemic, and the first half of the year was the worst on record in terms of both excess return and total return, according to Wells Fargo Securities. While the market may have calmed a bit recently, strategists say the selling and volatility is not over. "They are yielding much more than they did at the beginning of the year, but there's going to be a better time to buy them in the future," said Gilbert Garcia, managing partner of Garcia Hamilton Associates. "I predict the Fed, in their zeal to catch up... as they slam on these rate hikes in big chunks, they're going to put us in a recession." In the futures market Wednesday, a hot inflation report sparked speculation the Federal Reserve could raise interest rates by as much as a full percentage point when it meets later this month. The market was also pricing in nearly another three-quarter point hike for September. Garcia said aggressive Fed rate hikes could mean spreads — or the difference in yields between corporate bonds and Treasurys — could "gap out" in turbulent trading. He said there could be another 50 to 75 basis points at least in widening of the spread between investment grade corporate bonds and Treasurys. The spread on the ICE/BofA U.S. Corporate Bond Index has widened to about 1.59, meaning investment grade bonds are yielding 1.59% over the yields of comparable Treasurys, from about 0.98% at the beginning of the year. Yields rise when bond prices fall. Search for 'steady Eddies' "If you're really bent on getting them now, I would stick to the highest quality, meaning the very high single A-rated names. They will hold their value best," Garcia said. He noted that he would look among technology names — like Apple , IBM and Intel — and also in big pharmaceutical companies, but avoid financials. "These are names that are bulletproof," Garcia said. He said he would look to the "steady Eddies" like PepsiCo , Home Depot and UPS. "In the high grade paper, the corporate balance sheets are still very strong, they will maintaining their spreads and trade well," said Andy Brenner of National Alliance. He said an Apple 10-year bond, rated AAA by Moody's and AA+ by Standard and Poor's, for instance was yielding 3.66% Wednesday. An IBM 10-year bond, rated A3/A-, was yielding 4.25%, he added. "BBBs are the ones that are really going to hit the wall," Garcia said. BBB-rated bonds are those rated on the bottom rung of investment grade, just above junk. In times of economic stress, those lowest rated bonds are vulnerable to falling into the high yield, or junk, category, which means their prices could drop. The BBB tier had been an attractive play when the Fed was on hold and the economy looked to be improving, but that has changed with the investment environment. "You had an environment where global central banks did QE [quantitative easing] and they cut rates and it was amazing. There was a time when all prices went up — bond prices, equities, real estate, bitcoin," said Hans Mikkelsen, global head of credit strategy at Wells Fargo Securities. "This year is the opposite." Perhaps keep your powder dry and wait Exchange traded funds that track corporate bonds have mostly moved lower since the start of the year. For instance, investment grade bonds trade in iShares iBoxx $ Investment Grade Corporate Bond ETF, and high-yield issues trade in the iShares iBoxx $ High Yield Corporate Bond ETF . Mikkelsen said he is cautious on corporate bonds and a good holding for now is cash, but for investors who want to ride out the storm and hold on for yield, corporates are not all bad. "I think you're going to be able to buy even higher yields for the next several months," he said. "If you're an investor that's buying five-year paper, and you plan to hold it for five years, and you don't care about mark-to-market risk," some yields are attractive. But for many investors, they may want to keep their powder dry and wait. "We priced in a lot already. We're getting closer to the point where it's becoming more interesting to buy bonds," he said. "I think we have to wait for higher yields from here before buying bonds. But clearly it's a much better entry point right now." Mikkelsen said he is watching for the point where it looks like central banks are getting ready to back off after a rapid rate hiking cycle. "It really comes down to inflation. If inflation suddenly rolled over that could be very positive for risk assets," he said. For now, inflation shows little sign of letting up. The consumer price index for June was 9.1% year-over-year, the highest since 1981. Yuri Seliger, Bank of America credit strategist, said the market's sentiment is very negative right now, but he expects it could be better later in the year. "There's not a lot of demand to buy IG corporate bonds. There is little issuance. When the issuance comes, it prices cheap," Seliger said. "So people demand a big discount to buy IG." He said that is because of the uncertainty surrounding the Fed, interest rates, inflation, and growth. But Seliger said he is bullish on investment grade spreads, looking out to the end of the year. "Our six-month target is 130 basis points. That compares to 158 now," he said on Tuesday. Seliger expects spreads to widen in the third quarter but tighten again in the fourth quarter.

A street sign for Wall Street is seen in the financial district in New York, November 8, 2021.

Brendan McDermid | Reuters