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Where we see risk and opportunity in investment-grade corporate bonds

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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 fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Thomas H. Luster, CFA, Director of Quantitative Strategies, Diversified Fixed Income, Eaton Vance Management and Bernard Scozzafava, CFA, Director of Diversified Fixed-Income Quantitative Research, Eaton Vance Management

      Boston - Recent concerns in the U.S. investment-grade corporate bond market have centered on falling prices and widening credit spreads. However, we think the higher yields are starting to present opportunities for investors who are cognizant of company-specific, or idiosyncratic, risks.

      Also, much has been made of the fact that U.S. investment-grade corporates are on track for a slight loss in 2018 while U.S. stocks have sold off sharply. It's historically rare for both asset classes to post losses in a year, and we think investment-grade corporate bonds can provide downside protection for equities. It's also important to note that both rising interest rates and widening credit spreads contributed in about equal measure to corporates' 2018 losses.

      In other words, it could be a mistake to question the diversification benefits of U.S. investment-grade corporates for an equity portfolio based on one year's performance. The benchmark we use, the ICE BofAML 1-10 Year US Corporate Index, is down 0.9% so far in 2018. But that would be only its third negative return year since 1983 (the index lost 0.8% in 2008 and lost 2.0% in 1994).

      Recent weakness creates opportunity?

      We believe yields on investment-grade corporates are starting to look attractive after the recent weakness in bond prices. The yield on the ICE BofAML 1-10 Year US Corporate Index is above 4% for the first time since 2010.

      Meanwhile, credit spreads on the index have widened to 131 basis points, which is higher than the pre-crisis average of 112 basis points. In 2018, spreads have nearly doubled from the post-crisis low of 72 basis points in the first quarter -- even though underlying credit fundamentals have recently improved and we believe will remain sound unless there is a severe shock that tips the U.S. economy into recession in 2019.

      Finally, looking at the supply/demand forces in the investment-grade corporate market, we think the technicals should improve. Supply (issuance) has been running 10% lower than last year, while we think demand should eventually respond favorably to higher yield levels. In particular, foreign investors may be buyers as they continue to grapple with exceptionally low rates and weaker growth prospects in their markets.

      Focus on idiosyncratic risk

      Although overall U.S. investment-grade corporates are offering the highest yields in several years, we think investors do need to be aware of company specific, idiosyncratic risk. The recent woes of General Electric (GE) bonds are a reminder of this.

      Defaults are historically rare events in the investment-grade corporate market. The bigger risk is a downgrade from investment grade to high-yield or "junk" (a downgrade to BBB or BB rating).

      When we evaluate a company for inclusion in our corporate ladder portfolios, we always ask ourselves: Are we getting compensated for the risk? What is the potential downside?

      As the credit cycle ages, we believe fundamental research is more important than ever for corporate bonds. As the GE example shows, investors can't become complacent with big household names.

      Other recent examples of idiosyncratic risks in the investment-grade corporate market include:

      • PG&E and concerns about its equipment's role in California's worst wildfire.
      • Ford and the impact of auto tariffs.
      • British American Tobacco and the FDA's potential ban on menthol.

      The increasing size of the investment-grade corporate market is another reason why constant due diligence is required. A lot of the headlines focus on the market's growth from $2.2 trillion in December 2007 to $6.4 trillion currently. However, there are also a lot more issuers to keep track off, with over 1,150 today compared with 750 in December 2007. Again, this is just another reason why we think robust fundamental credit work is important in today's investment-grade market.

      Bottom line: While concerns about the level and potential further widening in investment-grade corporate credit spreads are getting most of the headlines, we think that idiosyncratic risk is a greater concern, especially in the short term.