As yield spreads between investment-grade and high-yield bonds narrow, investors should focus on credit quality.
The spread between these two types of bonds was around 325 basis points in mid-August, which is slightly above the historical median and “still somewhat attractive,” says Nicholas Leach, vice-president of global fixed income at CIBC Asset Management.
“But we shouldn’t look at the [yield spread] in a historical context alone,” said Leach in an Aug. 19 interview. “We need to look at the credit quality of investment grade and high yield, and see how it has changed over the years.”
Credit quality between the two has also narrowed, according to Leach, who manages the Renaissance High-Yield Bond Fund. Triple B-rated bonds, the lowest quality, currently represent 50% of the U.S. investment-grade market. This is an increase from 40% several years ago.
As a result, “the overall credit quality of investment-grade corporates has deteriorated,” noted Leach.
Also consider the ratio of that spread to the absolute level of yield, he said.
“When we think about a 325 basis-point spread differential, this is actually far more meaningful when investment-grade corporate yield is averaging less than 3%, compared to 5% to 6%, which is where they were yielding 10 years ago. So, a 325-basis-point spread differential is actually a multiple of the investment-grade corporate yield, not a fraction of what it has been historically.”
Leach said it’s also important to look at duration.
“The duration on investment-grade corporates has been rising,” he said. “So investors should get some additional compensation for taking on that duration risk, which is much higher than what it is in the high-yield market.”
Outlook for corporates
Bond yields in various countries have turned negative, including 10-year bonds in Germany and Japan. Europe’s broad-market bond average yield in mid-August was about -0.2%, noted Leach.
“[That’s] about $16 trillion euros worth of bonds that have a negative yield,” he said, including about $1.1 trillion euros of negative-yielding corporates.
Companies can go into that market, issue debt, and pay back less than what they borrowed, Leach said.
As a result, it’s a “huge incentive for stimulating new issuance.”
Meanwhile, U.S. investment-grade corporates are yielding about 3%, and high yield is about 6%, he said. Fixed-income investors who want positive yield “have almost no other place to turn to other than U.S. corporate credit.”
Leach added: “As these global sovereign bond yields, especially in Europe, continue to sink into negative territory, this is going to provide a very strong supportive technical bid to North American corporate credit, both investment grade and high yield.”
Also, Leach said it’s “widely anticipated” that the Fed will continue to lower its funds rate after cutting in July. And as U.S. short-term interest rates decline, it’ll be cheaper for non-domestic bond investors to hedge that currency risk.
“The U.S. corporate credit bond market is going to look even more attractive to those foreign investors,” he said.
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