Not surprisingly, corporate credit spreads widened dramatically back in March 2020, making corporate bonds cheap relative to historical averages. (Credit spreads are the extra yield corporate bonds offer versus similarly dated Treasuries). But things happened fast in 2020, and, as shown in the LPL Chart of the Day, corporate spreads have narrowed considerably, already reaching a level that wasn’t seen after the 2008–09 recession until 2013, based on monthly data.
“While stocks may have gotten a little ahead of themselves, it’s reassuring to see the often more cautious credit markets agreeing with stocks’ positive assessment of the economy,” said LPL Financial Chief Market Strategist Ryan Detrick. “The downside for fixed income investors is that the performance tailwind from tightening spreads likely won’t have a whole lot left to it.”
Some observations about credit spreads:
- High-yield spreads are in the 41st percentile of their 15-year range, while investment-grade spreads are in the 26th percentile (lower percentile means tighter spreads).
- High-yield spreads are 1.72% above their 15-year low (using monthly data) while investment-grade spreads are only 0.29% above their 15-year low.
- Over the last 15 years, high-yield spreads have moved, on average, 2.7% for every 1% investment-grade spreads moved. When spreads widen, bond prices tend to fall.
Both investment-grade and high-yield credit spreads are near what we would consider fair value at this point, considering we may be in the early stages of an expansion. There are still some risks, however, due to the surge in COVID-19 cases and the extent to which it may lead to a second lockdown. For investment-grade corporates, further spread narrowing is increasingly unlikely to offset potential Treasury yield increases, which could provide some price headwinds if we were to continue to see rates rise. Investment-grade corporates have grown increasingly rate-sensitive as companies continue to borrow at longer maturities. While high-yield corporates are significantly less rate-sensitive, they are also riskier and tend to move more with stocks, and therefore, provide little of the historical diversification benefits of broad investment-grade bonds.
We still see incremental value in investment-grade corporates over Treasuries, although the relative attractiveness is declining, and we see more value in mortgage-backed securities (MBS). On a tactical basis, we prefer equity exposure to high-yield bonds. High-yield bonds, however, may be attractive for suitable income-oriented investors, but will also be more vulnerable if we were to experience an economic downturn.
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