Midyear Outlook: Corporate Bonds and Muni Bonds

KATHY JONES: I'm Kathy Jones. 

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week we analyze what's happening in the markets and discuss how it might affect your investments.

So Liz Ann, last week we did get a lot of data about the health of the economy. We had the Fed's inflation gauge, the core PCE, and that rose pretty modestly in April. What did the markets make of that?

LIZ ANN: Well, it depends on what markets and what components of markets, I guess, when talking about the equity market. You know, the indexes obviously have done well. NASDAQ is around an all-time high. Same with the S&P 500®. Small caps, a little bit choppier performance. So in general, that was a good report in the sense that it alleviated some of the concerns that had arisen given some of the hot readings in every inflation metric in the first few months of the year. 

But we've also had some economic data that has been a little bit weaker, if not, yet again, expressing cross currents. We've had the readings on ISM, at least manufacturing, that was weaker and that went against the other version of PMIs that's put out by S&P Global a couple of weeks ago that were hotter than expected, and that caused some problems in the market. So I continue to think we're in this environment of cross currents.

I know we're going to talk about what we're focusing on next week, but we've got, you know, incoming inflation reports next week that are extremely important.

What about you? I continue to think that bond yields are somewhat in the driver's seat for the equity market, maybe a bit more recently down the cap spectrum as opposed to the mega-cap dominated indexes. But what are your thoughts on this recent move down in yields? And are you expecting that to continue or something range-bound?

KATHY: Yeah, I think it can continue. I think there's room for yields to fall further, but it's likely to continue to be really volatile. You know, as long as inflation continues to work lower, and the labor market returns to more normal wage growth, which is what we've seen recently, there's room for rates to come down and for the Fed to cut. But with the Fed being data dependent, every report has outsized, you know, significance to the market. And that just gives us this roller coaster of up and down, up and down, with every single data point. And I think that that will continue to be a feature going forward, even if the overall trend is lower as we expect, volatility is likely to stay pretty high.

LIZ ANN: Well, it's that time of year, and next week our episode will feature our collective mid-year market outlooks for equities, for the global markets, what's happening in Washington. But starting this week, we're focusing on fixed income.

Kathy, it's been a busy year in terms of tracking various Treasury yields, but also in the world of munis and the increased demand for corporate bonds. So how would you describe the first half of the year and thoughts on the second half of the year?

KATHY: I would describe the first half of the year as somewhat surprising, and as I mentioned earlier, a bit of a roller coaster. You know, it came into the year with the economy looking sort of soft and expectations for a series of rate cuts. But then in Q1, the economy rebounded, you know, resilient consumer spending, and inflation got a little bit sticky. And so the market expectations went from, you know, pricing and as much as six rate cuts to no rate cuts within just a matter of weeks. And of course, we had long-term yields move up pretty quickly as well.

But now as we approach the end of Q2, some of that economic softness seems to be showing up again. Inflation is still easing, so yields are starting to come back down. As we look into the second half of the year, we're still looking for the Fed to cut rates. We started the year expecting three to four. We narrowed it down to one to two, but I think the drivers behind those rate cuts are still in place. That is, you know, inflation's coming down. Real rates are high. If you keep the fed funds rate at 5.25 to 5.5%, and core PCE is down at 2.75 or below, you've got close to 300 basis points in real rates. And that allows the Fed to cut somewhat. It's also a global rate-cutting cycle. We're seeing other major central banks start to cut. 

So I think you can sum it up as we expect the Treasury market to continue to normalize with yields coming down, and eventually the yield curve should un-invert, steepen somewhat with short rates and long rates flattening out at some point, and even having short rates below longer-term rates. But that's a 2025 argument, I think. But again, volatility likely to be pretty high. And that's going to make another kind of interesting and challenging market.

But I do want to emphasize that we're encouraging our clients to look beyond the Treasury market for opportunities in fixed income. And that's the conversation that I've had with my colleagues, Collin Martin and Cooper Howard.

LIZ ANN: Obviously we've had both Collin and Cooper on in the past, but maybe people who haven't listened to that episode or aren't familiar, tell us about both of them.

KATHY: Sure, they're fantastic colleagues of mine in the fixed income research area in the Schwab Center for Financial Research. So Collin Martin and Cooper Howard, both are on the team and make huge contributions to everything we do.

Collin's a director and a Chartered Financial Analyst, CFA®. And his focus is on the taxable credit markets. Collin's a frequent guest on Bloomberg TV. He's been quoted widely in financial publications, including The Wall Street Journal and Reuters and MarketWatch.

Cooper is also a director and an expert on the municipal bond market, which is an important market to a lot of individual investors. He also has been quoted in many financial publications, The New York Times, Bloomberg, The Bond Buyer, all of the places where people look to get that sort of financial information.

And to read the full mid-year outlook that we've put together, go to schwab.com/learn, and you'll find it under the fixed income drop-down tab. And we'll put a link to that in the show notes.

Cooper, Collin, thanks for joining me today to talk about the fixed income outlook for the second half of 2024.

In general, we're looking for the potential for one or two rate cuts from the Fed and lower yields as inflation and growth moderate. But the Treasury market has already discounted that likelihood. I mean, the yield curve is inverted. That means short-term rates are already higher than long-term rates. So even if our scenario plays out, there may not be that much bang for the buck in the Treasury market. So one of our themes is "look beyond Treasuries." I mean, Treasuries are a core holding for most people, but there's a lot more bond market out there to explore. And that's why we have you two here today.

So Collin, I'm going to start with you and talk about the taxable bond market and what you see in the second half of the year. Can you just start with investment-grade corporate bonds?

COLLIN MARTIN: Yeah, absolutely, and thanks for having me, Kathy. Investment-grade corporate bonds are one of the areas that we really like right now. We think the yields are really attractive. And I know a theme that you've been talking about, and we've been talking about, is the idea of considering some intermediate or longer-term bonds to kind of lock in that yield based on our outlook for the Fed to cut rates. So we'd rather have investors lock in those yields and not have to worry about what the Fed does. And we know a concern, when you look at the Treasury yield curve like you alluded to, is the idea of accepting a lower yield by moving further out on the yield curve and considering intermediate-term Treasuries. That's less of an issue with investment-grade corporate bonds. So the yields they offer is really one of the main reasons why we really like them right now. If you consider an average yield of the investment-grade corporate bond market of around 5.5%, but even if you look at specific parts of the yield curve, specific maturities of five, seven, 10 years, you can generally get average yields of 5.3, 5.4% or more, depending on the credit rating, depending on the specific maturity. I just think that's really important because that's very similar to what you can get with Treasury bills or short-term CDs or money market fund yields. So this is a way to get very similar or even higher yields, but locking those in for a longer period of time. So we think that's really important. 

Now there are risks with investment-grade corporate bonds, especially when you consider intermediate term because you have both interest-rate risk, which can mean price fluctuations in the secondary market, and credit risk because corporations issue these bonds, not the U.S. government. So there's the risk that maybe something happens with the corporation that's issued those. But generally speaking, we think fundamentals are OK. We're seeing corporate profits continue to rise. We look at data from the Bureau of Economic Analysis, and corporate profits hit another all-time high as of the last reading.

And one thing that makes investment-grade corporate bonds relatively attractive is less refinancing risk for the issuer. So what we saw in 2020 and 2021 was a lot of highly rated investment-grade issuers issue more long-term debt when yields were very low. And investment-grade corporations tend to have a more diversified debt profile, so they don't constantly have debt coming due all the time. So the rise in borrowing costs that we've seen lately really only impacts those issuers who might be having debt come due soon, but it's usually not all at once. We think that's a positive.

And then finally, an issue we've talked about, Kathy—we've talked about this for a while—is the rising share of BBB-rated corporate bonds in the investment-grade corporate bond market. So when we talk about investment-grade, that is as high of a rating as AAA and then down to BBB. So that's the scale of investment-grade rated bonds, BBB being the lowest rung. The next rung after that is what's called high yield. Now BBBs have been making up a rising share, and up until 2019, they actually made up about 52% of the Bloomberg U.S. Corporate Bond Index. But it started to come down. Now it's about 47%. So it might seem like it's just a modest decline, but the idea that we're seeing fewer BBB-rated issues and more A- and AA-rated issuers, meaning higher-rated issuers, that's a good thing too, and that the credit quality has improved over the past few years.

KATHY: Yeah, I think those are really important points. But when you talk about, "Well, the yields look good," I mean, high yield, what's not to like about 8% or higher in the high-yield bond market? So do you think we should dabble in that market as well?

COLLIN: So in the high-yield market, you can dabble, but we are still a bit cautious there. And when we talk about high-yield bonds—we just talked about investment-grade corporate bonds. So again, those are ratings of AAA down to BBB. When you get to BB or below, those are called high-yield bonds. You might hear them called junk bonds. They come with a lot more risks. They tend to default more often. They tend to have more volatile cash flows. They tend to have a lot more debt on their balance sheets. And in a rising borrowing-cost environment like we're seeing right now, that just means more of a burden and higher … they see that rise in interest expense, likely more than an investment-grade issuer would. 

And we are seeing defaults pick up. We get default data from both Moody's and Standard & Poor's, and the default rate has been gradually rising. And depending on which agency we look at, default rates can be in the 4, 5, or 6% area, generally slightly above the long-term average. But the trend has been up. And it could remain elevated, especially given the potential for a higher-for-longer interest rate policy period. Even if the Fed cuts a little bit, yields are still relatively at a high level, and that can be a challenge for high-yield issuers.

But what makes us most concerned—because those risks are kind of always there. They have low credit ratings for a reason. But a risk we see is just the lack of compensation that we as investors earn when you consider high-yield bonds. So you mentioned that 8% average yield, Kathy. Most of that 8% yield really just comes from the level of Treasuries, because high-yield bonds are priced based off of a Treasury yield and then a spread, or a yield advantage to accept the risks that high-yield bonds offer. And that spread's only around 3% right now. It's well below the long-term average. It's not too far off the cyclical low that we saw back in 2021. And we think it makes sense to take risks if you're being compensated for it. But with spreads so low, we just don't think investors are being compensated too well.

So you know, I said you could dabble in high-yield bonds if you have a long-term investing horizon. Again, 8% is attractive in absolute terms, but we have to assume that there could be some credit losses in there due to defaults over time, and their prices tend to fluctuate more than high-quality bonds. So if you have a long-term investing horizon, you can consider them, but we wouldn't be overweight them right now just given that lack of what we think is an attractive yield advantage. At 3%, that just seems too low for us.

KATHY: So Collin, you know the answer to this, but one of my favorite bond jokes—and yes, people, we do have bond jokes. We're funny people when we want to be. But what's the difference between a high-yield bond and a junk bond?

COLLIN: You tell me, Kathy.

KATHY: Haha! That's my favorite joke.

COLLIN: I know, but you tell me.

KATHY: OK, it's high yield when you buy it. It's junk when you go to sell it. 

COLLIN: Haha!

KATHY: So that's the warning I like to give people. Like, it doesn't always work out. You can't have as much confidence with the high-yield market as you do with the investment-grade market. OK, so enough with jokes. Let's get to one other area that we have liked for a while. And this is, again, in the sort of aggressive income area of the portfolio that we talk about. What about preferred securities?

COLLIN: Yeah, preferred securities are something we talk about a lot. They tend to be issued more for retail or individual investors because they have lower investment minimums, smaller par values than what traditional bonds have.

But let's take a step back and just talk about what preferreds are. They're hybrid investments, and they have characteristics of both stocks and bonds. So they do have those par values like bonds, albeit smaller denominations. But like stocks, they rank lower than your traditional bonds. So that's where there's more credit risk there, and a lot of them actually are considered equity from a from a balance sheet standpoint.

One thing that's really important when considering preferreds is that they generally have very long maturities or no maturities at all. So they should always be considered long-term investments, and that's going to be key.

Now when we talk about yields, they do offer higher yields mainly because of those risks. You can get average yields today of 6 or 6.5 percent. So that is higher than what you can get with investment-grade corporate bonds, and it's generally lower than what you can get from high-yield bonds. So it kind of fits in between those from a yield standpoint but also, I'd say, from a risk standpoint. While those yields seem pretty attractive in absolute terms, the advantage that preferreds offer relative to investment-grade corporates is relatively low. It's only about one percentage point or 100 basis points right now. Historically, it's been higher. That's generally the theme with a lot of investments today because the economy has proven to be resilient. We've seen the yield advantage that riskier investments offer kind of come down a little bit, and that is the case with preferreds.

There is one potential benefit with preferreds when considering them in an investment portfolio, and Cooper's going to talk about some tax benefits as well when we talk about municipal bonds. But some preferred securities, specifically preferred stocks, are taxed at a lower rate than the income that bonds offer. So that can make them a little bit more attractive. I think the key thing to consider though is that long maturity or no maturity point that I mentioned before. If you are looking for income, and you can ride out the ups and downs, then I think there is a place for preferreds in a portfolio, I think, in moderation, as long as you're prepared to hold for a while, because those income payments can be attractive, but they do come with a lot of volatility.

KATHY: Thanks, Collin. Those are great points and a perfect segue over to Cooper to talk about the municipal bond market. Cooper, I'm going to pull you in because a lot of the same themes apply in terms of low spreads, the narrowness of those spreads, and also our focus on quality. But just give us a quick recap of what's happened so far this year in the muni market.

COOPER HOWARD: Yeah, thanks for having me on, Kathy. And Collin brought up some good points, and you're going to hear kind of a similar theme throughout our conversation that Collin had mentioned. So to start off the year, it's been a relatively difficult year so far. If you look at returns for just the broad municipal bond index, they're down about 1.5% year to date. But we do expect that to get better. And really, I'd lay out two reasons why we expect it to get better.

The first is starting yields are actually much more attractive now. So if you look at the total return makeup of a fixed income portfolio, part of it is due to the coupon that you receive. Also, the other piece of it is due to price fluctuations, usually due to changes in interest rates, sometimes changes in credit quality. But because those coupons are higher, that should really help to offset some of those price fluctuations and help to offset some of the negative return that we've seen so far this year.

The second reason why we think that returns are likely to improve later down in the year is because our outlook is that it's more likely that rates will move lower rather than higher. So there's an inverse relationship, Kathy, with yields and prices. So if yields move lower, then prices should move higher. So if our view that yields move lower is correct, that should help increase some of that price total return. So even though it's been a rough start to the year so far for the broad index of munis, we do expect that to improve going forward.

KATHY: It sounds like you do think munis are an area of opportunity, particularly for people in higher tax brackets, higher tax states. Can you tell us about what you see in terms of the opportunity?

COOPER: Yeah, and you're correct. We do think that munis are an area of opportunity, and especially for those investors who are in higher tax brackets. Because if you look at absolute yields—absolute yields, when you compare them after taxes, they are very attractive. If you look at relative yields, they're not so attractive, and I'll kind of get into that.

So one of the metrics that we'll commonly look at is the tax-equivalent yield. Now, Collin had mentioned some of the tax benefits of preferreds. The tax benefits of municipal bonds are that they usually pay interest income that's exempt from federal income taxes as well as state income taxes if it's purchased from your home state. So one of the metrics that we'll look at is what's called the tax-equivalent yield. And that basically is the yield, if that bond were to be fully taxable, what would it have to pay? And so for an investor in the top tax bracket in a high-tax state like California or New York, that tax-equivalent yield is above 7%. So we think on an absolute basis that it's very attractive compared to where we have been historically.

Now the other metric that we'll commonly look at is a relative yield. Usually municipal bonds are compared to Treasuries because, generally speaking, they tend to be very high credit quality to begin with. And relative yields, they're not so attractive now. So the metric that I like to watch is called the muni-to-Treasury ratio. And Kathy, all that that is, is it's a ratio between the yield on a AAA-rated municipal bond to that of a Treasury of similar maturity. And that's right now about the mid-sixties. So the way you can look at that is that if a municipal bond pays 3%, and a Treasury bond pays about 5%, that's considered about the mid-sixties of that ratio. So 3 divided by 5. Now for an investor who's not in the top tax bracket, really that means that they could probably get a higher after-tax yield by looking at Treasuries or CDs after considering the impact of potentially having to pay income taxes on that.

KATHY: That's something we talk about a lot with clients, and I think there is something about the earning tax-exempt income that people just really like. A lot of times, they just don't want to pay taxes if they don't have to. Yeah, but I think it is important to compare it to where you would be in a taxable equivalent. So that's good.

What about the credit quality in municipal bonds? You know, a lot of people are worried about the federal government's finances. What about state and local governments?

COOPER: Yeah, so this is another reason why we do think that municipal bonds are going to be an area of opportunity in the second half of the year is because credit quality, it has probably peaked, and we are starting to see a rolling over of it, but we still do think that the backdrop is relatively strong.

So we came into the year really with a positive outlook on credit quality. We actually suggested adding some lower-rated investment-grade bonds. Those would be like A-rated issuers or BBB-rated issuers, in moderation. That was actually kind of a good call because those parts of the market have actually outperformed higher parts of the market or the higher-rated portions of the market. So not really to do a little victory lap here, but it had been a good call. But we're starting to get a little bit more cautious on taking credit risk, in my opinion. Now, I don't think the backdrop is really all that negative. So I'm not saying it's "Chicken Little, the sky is falling," but we are starting to see a little bit of a rolling over.

Now, one of the things that I think was really a big game changer in the municipal bond market was COVID. So coming into COVID, things were kind of humming along, going OK. Out of COVID, you saw tax revenues increase quite a bit. There was substantial amount of fiscal stimulus that was provided to state and local governments. So really things were good on multiple fronts, and that really helped to boost credit quality overall. If you look at the broad index, about 70% of the bonds in the broad index are either AAA or AA rated. And that's the highest credit quality going back to all the way down to 2008, 2009. So the backdrop today is still relatively positive, even though we're starting to see a divergence with state tax revenues.

So if you look at a trend between what would tax revenues be between 1990—if you ran a trend line between their tax revenues beginning in 1990—all the way up to COVID and kind of continued that trend along. Now, there are 45 states that are still above that trend line of where their tax revenues would be. So they are still receiving some relatively good footing. However, there are obviously five states that are below that trend line. I think the most notable is California. So they have about 2.5% below what that trend revenue would be. So we don't think that this is a major cause for concern at this point, but because California is the largest issuer of municipal bonds in the market, I do think that it's something notable and an area of where we're starting to see a little bit of a divergence and a little bit of a concern of credit quality going forward. So again, we don't think it's Chicken Little. We don't think that the sky is falling, but there are starting to be a little bit of a rolling over in credit quality.

KATHY: That's great perspective. But just tell me quickly, when we're talking about credit quality in these major states that have diverse economic bases, huge populations—we're not talking about a huge problem in the market. We're talking about just a relative deterioration from a high level. Is that correct?

COOPER: Exactly. So again, about 70% of the bonds in the market are either going to be AA or AAA. So they're going to be very high credit quality to begin with. And if you see some deterioration in credit quality, they are starting off on a very strong footing. So even though if there is some deterioration, we don't think that it's going to be like the entire market's going to slip into high yield or junk rated.

So we still think that going forward, it's likely that the vast majority of municipal issuers will be able to meet their debt service on time. We still think that municipal bonds are going to be a relatively conservative investment compared to some other portions of the market. So we still think that those characteristics should continue going forward.

KATHY: Great, so I don't have a joke for you. I don't know if you have a muni joke or not. But I do have one question that I have to ask just because of the timing of this. We're looking at the second half of the year, and I believe there's an election coming up. How might that affect the muni market?

COOPER: So what you're telling me is that Collin gets the fun joke and I get the difficult election question.

KATHY: Haha! Sorry.

COOPER: All right, I'll remember that for next time. I think that there's probably two ways that it could impact the muni market, Kathy. The first is that we've really seen a surge in issuance so far this year. That was also one of the reasons why we haven't had relatively good performance so far. So I think that a lot of issuers are really front running the election and issuing bonds today rather than issuing them later on in the year. There's really kind of a supply-and-demand dynamic in the municipal bond market that impacts yields as well as total returns. So I think that one—issuance is likely to be lower later in the year because a lot of that has already taken place at the beginning of the year.

Now, the second area that I could see creating some volatility in the muni market is that the tax law changes. We know that the 2017 tax laws expire at the end of 2025. So it's likely to be a hot topic on the campaign trail. And because of the tax advantages that municipal bonds offer, they tend to be relatively sensitive to changes in tax laws. So even though tax law changes likely won't occur until later into whoever is elected as president—and it's really going to depend on the makeup of Congress—I think any talk of that could potentially create some headline volatility. So you might see some investors react one way or another to a potential proposal even though that proposal won't actually be implemented or may have a far chance of being implemented. So we'd caution our investors from kind of overreacting from different things that they see as far as proposals on the campaign trail.

KATHY: Yeah, that's a good point. Plus, I think it's good to remind people that Congress actually sets these laws, not the president. So the candidates can say anything they want, but when it comes down to it, it's Congress has to get together and come up with the laws that actually go into effect. So not overreacting seems like a good idea.

COOPER: Exactly.

KATHY: Thank you both. We could sit and talk about bonds all day, but I think that probably hits the high points. So thank you, and looking forward to the second half of the year.

COOPER: Thank you, Kathy.

COLLIN: Thanks, Kathy.

LIZ ANN: So Kathy, it's a big week next week, including the Fed meeting. Besides that, what do you think investors should be watching in the week ahead?

KATHY: Well, we'll be getting those jobs numbers this coming Friday, the day this airs. So those will be significant. But I do think that we need to keep an eye on a couple of developments outside of just the fixed income markets or the economic calendar.

We've seen recently a pretty big tumble in some commodity prices that seems to reflect the slowdown in global demand. We're seeing some soft growth in many parts of the world. And I think that's worth keeping an eye on. That can have a pretty disinflationary impact. And of course, that can be important for the bond market, along with all the standard economic reports. We'll be focused most squarely on that Fed meeting.

How about you, Liz Ann? What are you keeping an eye on for next week?

LIZ ANN: As you certainly know, with the June meeting, although we don't expect anything from the Fed in terms of any move on rates, it is the release of the updated Summary of Economic Production and the so-called dots plot, so those always get massaged. These days, press conferences, even in a meeting where nothing was done on rates, can be really interesting. So I think that's a sort of must-see TV, watching those press conferences.

And then at the end of the week next week, we get University of Michigan consumer sentiment. There's been some interesting trends and weakness on the consumer confidence side of things. We'll have to see whether that's corroborated by University of Michigan.

And to reiterate, we are taping this in advance of Friday's jobs report. So I would suggest take a look at our Twitter feeds (or X feeds) because that's where we both post a lot of in-the-moment reaction to that data, which is not, unfortunately, covered in this week's episode.

So as always, thanks for listening everybody. That's it for us this week, but you can always keep up with us in real time on social media. I'm @LizAnnSonders on X and LinkedIn.

KATHY: And I'm @KathyJones. That's Kathy with a K on X and LinkedIn. If you've enjoyed the show, we'd really be grateful if you'd leave us a review on Apple Podcasts or a rating on Spotify or feedback wherever you listen. You can also follow us for free in your favorite podcast app.

For important disclosures, see the show notes or visit schwab.com/OnInvesting.