Credit Spreads Limit Bond Performance Outlook
Posted by lplresearch
Economic Blog Investment-grade credit spreads, the extra yield you get from investment-grade corporate bonds compared to similarly dated US Treasuries, have already tightened to a level you usually only see during the middle of the economic cycle—and that can have consequences for bond investors. As shown in the LPL Chart of the Day, the current spread as of January 15 was at 1%, close to the tightest level of the previous cycle of 0.91%, hit in February 2018, and in the bottom quarter of all values going back to 1997.
“Corporate bonds will likely get support from an improving economic outlook as vaccines become more widely distributed,” said LPL Research Chief Market Strategist Ryan Detrick, “but you’re not getting a whole lot of compensation for the added risk anymore.”
Tighter spreads are a strong sign of investor confidence that the economy is likely to continue to get back on track. At the same time, it makes corporate bonds relatively expensive and can increase their sensitivity to Treasury yields. When spreads have room to tighten, it can help offset rising Treasury yields. When spreads are already tight, the potential offset is small at best and may not occur at all.
We still see incremental value in corporates over Treasuries. That 1% of added yield over Treasuries from credit spreads remains attractive for many investors, especially if the economic outlook is positive. There are also shorter maturity investment-grade corporate options that may help limit rate sensitivity. There would be some lost yield at shorter maturities, but with sensitivity to changes in Treasury yields already increased by tight spreads, we think the trade-off is worth it.
With corporate spreads tight, our primary emphasis within investment-grade bonds remains mortgage-backed securities, where we believe the yield for the amount of underlying rate risk provides an edge over other investment-grade bond sectors.
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