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Bond Market Shifts

Now is a good time for investors to re-balance their fixed-income portfolios and add more government bonds. As the stock market reaches new highs, analysts remain concerned that investors are too complacent about risks, such as escalating trade tensions with China, a slowing in earnings growth and the expectation that the Federal Reserve will keep hiking interest rates. The same risks have analysts uneasy about the health of the corporate bond market. Bond traders suggest investors consider making some adjustments to their fixed-income portfolios now.

The bond market has undergone a recent shift in the relative performance of corporate bonds and government bonds. Investment grade corporate bonds were poor performers relative to Treasuries in the first half of the year but have done better lately. In bond market parlance, people can say that corporate credit spreads have tightened or the interest rate differential with Treasuries has narrowed. That is usually a sign that investors are more positive about the state of the economy and foresee lower risk in corporate debt. This may be a short-lived phenomenon. Investors may now have an opportunity to re-balance their bond portfolios, taking some profits in investment grade corporates and adding that to Treasuries. One advantage of this plan is that the yield on the 10-year Treasury has risen above 3%, which strikes me as a decent yield for government-backed securities. Analysts say, “We don’t foresee longer-term Treasury yields rising much more and that bond prices move inversely to interest rates, so it seems like a good time to add some duration to your portfolio. Conversely, investment grade corporates look riskier. The Federal Reserve is poised to hike short-term rates a full percentage point over the next year, which stands to raise borrowing costs for firms. The past 10 years since the financial crisis has included a surge in investment grade corporate debt issuance and much of it has been sold to foreign buyers, who may have lower appetites going forward if the dollar weakens from current peak levels.

Corporate fundamentals may not support further tightening of credit spreads. Companies are highly indebted and have less cash to cover interest, despite the strong earnings and cash flow growth. In the next recession, liquidity could become an issue. Investors should not look to the recent tightening in corporate credit spreads for reassurance that the economy isn’t poised to slow. Current pricing may prove an opportunity for re-balancing into longer-term government bonds, which have provided higher yields recently

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