The Department of the Treasury and the Internal Revenue Service released new guidance that is “designed to expand the use of income annuities in 401(k) plans.”
A global search for yield led fixed-income investors to pad their portfolios with U.S. investment-grade corporate bonds in 2012.
While these bonds have historically experienced low levels of default, they remain exposed to market risk should interest rates spike from their abnormally low levels. The interest rate risk facing corporate bond investors is exacerbated by the high proportion of fixed-rate debt issued of late, which accounted for 96 percent of U.S. corporate bonds sold between September to November 2012, versus 60 percent in 2007, according to SIFMA.
A return to higher interest rates will certainly affect fixed- income investors with longer duration bond portfolios, and timing remains key. A number of variables will aid in determining losses for holders of U.S. corporate bonds, but Fitch Ratings notes the speed at which rates will rise is among the most critical.
For instance, if interest rates were to revert rapidly to early 2011 levels (a 200 basis point rise), a typical investment-grade U.S. corporate bond (rated 'BBB' with a 10-year maturity) could lose 15 percent of its market value assuming constant spreads, as explained in Fitch's recent report "The 'Bond Bubble': Risks and Mitigants." An orderly reversion would make for an easier investor landing. If rates rose at a more gradual pace, losses would be mitigated by the coupon income received and the shorter remaining maturity.
Very simply, if a rise in rates were to take place over a one year period, the loss on a typical 'BBB' 10-year U.S. corporate bond might be closer to 9.5 percent. Given a two-year window, the potential loss would be even lower at roughly 3.5 percent. The U.S. Federal Reserve said in December 2012 it would keep short-term interest rates near zero at least through mid 2015. While a continuation of accommodative monetary policy would reduce the likelihood of a sudden spike in rates, it could exacerbate existing imbalances, as an increasing share of investor portfolios would consist of lower coupon securities that are particularly vulnerable to rising rates.
We also note that while a jump in interest rates could translate to significant market value losses, the largest holders of U.S. corporate bonds (U.S. life insurance companies at $2.1 trillion) would likely be able to mitigate losses in a rising rate scenario via asset-liability management and regulatory capital levels will remain stable as statutory accounting rules heavily utilize book value when marking assets.
Additional information is available on fitchratings.com.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at fitchratings.com. All opinions expressed are those of Fitch Ratings.
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