The decline in spreads is bad news for investors in real estate company bonds
Many investors expect corporate bonds to yield a significant excess return over government bonds. However, is the current risk premium justified given the global rise in yields to maturity and persistent economic threats?
The author is one of the founders and owners of the Meitav investment house.
The market for corporate bonds, which barely existed 20 years ago, has become an integral part of the Israeli capital market since the 2005 Bachar reform. Currently, nearly a thousand series of corporate bonds are traded, with a total value of approximately 650 billion shekels. A significant portion consists of real estate companies—ranging from residential construction to commercial properties—and financial institutions such as banks and insurance companies. For context, the entire Israeli government bond market is valued at about 860 billion shekels.
Beyond individual bonds, investors utilize baskets like Tel-Bond 20, 40, and 60, as well as ETFs tracking these indices.
Official and Market Ratings
Corporate bonds are distinguished by ratings from Maalot S&P and Midroog Moody's. The primary test for these agencies is cash flow, which ensures interest and principal payments, rather than company profit. Issuers also vary by duration and collateral.
Investors buy corporate bonds for the potential of higher yields compared to government bonds of similar duration. This difference is known as the spread. However, the spread is not just a risk premium; it is a daily market assessment of the issuer's reliability.
Currently, average spreads for investment-grade bonds are: 0.5% for AA+, 0.6% for AA, 1.0% for A, and 1.9% for BBB. Unrated bonds average a 3.1% spread. By sector, banks and communications trade at 0.5%, energy at 0.7%, and construction at 1%.
International Context and Historical Lows
While US spread trends are similar, it is crucial to note that US ratings are international, whereas Israeli ratings are local. An AA rating in Israel reflects a position 4–5 grades lower on the international scale. Currently, spreads are at all-time lows.
Is this justified? While falling interest rates in Israel benefit the business sector, internal and external risks remain. The ongoing multi-front military campaign has economic consequences, particularly for residential construction. A 1–2% yield premium over government bonds hardly compensates for these risks.
Liquidity Risks and Rising Government Yields
A significant threat is the potential for fund outflows during market downturns and a liquidity crisis. Furthermore, distress in the private debt market could spill over into tradable bonds.
A central risk today is the rise in government bond yields due to fears of escalation in the US-Iran conflict. 30-year US Treasury yields have reached 5.1%, with 10-year yields at 4.6%. Similar increases are seen in Germany (3.2%), the UK (5%), and Japan (2.8%).
This trend is expected to negatively impact the stock market and the corporate bond sector. Corporate bonds face a double blow: price declines due to rising market rates and the expected widening of spreads themselves.
This material should not be seen as an investment recommendation or a substitute for independent judgment. The investment house manages, among other things, bond mutual funds.
