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(Runtime: 4 min, 24 sec; size: 3.80 MB)
Nicholas Leach, vice-president, CIBC Asset Management.
So when we look at the spread differential between investment-grade bonds and high-yield bonds in early August, or mid August, we’re around 325 basis points. This is just slightly above the historical median, so it is still somewhat attractive. But we shouldn’t look at the differential just in a historical context alone. We need to look at the credit quality of investment grade and high yield, and see how it has changed over the years. So when we look at the credit quality, the differential between the two is actually narrowed. When you look at triple B’s, which are the lowest rated group within the investment-grade side, those triple B’s now represent about 50% of the investment-grade market in the US. And that compares to less than 40% seven year years ago. So the overall credit quality of the investment-grade corporates has deteriorated somewhat just in terms of the credit ratings.
And another important context to look at is the ratio of that spread to the absolute level of yield. So 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, say, 5% to 6%, which is where they were yielding 10 years ago. So in other words, 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. And in addition to that, we have to look at duration. And the duration on investment grade corporates has been rising. 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.
As we sit here, again in the middle of August, global bond yields are negative in so many different parts of the world, especially in Europe when we look at sovereign bond yields. The European broad market bond average yield, right now, is negative 0.2%. So we’re looking in Europe at about 16 trillion euros worth of bonds that have a negative yield. And that even includes corporates: 1.1 trillion euros worth of corporates have a negative yield. So companies like BMW can go into the market and issue debt, and actually have to pay back less than than what they borrowed. So it should be a huge incentive for stimulating new issuance, especially in Europe. And even U.S. companies can go to Europe and issue negative yields if they have the high credit quality.
So meanwhile, at the same time, when we look at U.S. corporates, the average yield for an investment grade corporate, in the corporate bond market in the U.S. is around 3% and in high yield it’s around 6%. So globally, investors, fixed income investors, bond investors that are seeking to have a reasonable positive yield, they have almost no other place to turn to other than U.S. corporate credit in North America, both Canada and in the U.S.
So we continue to think that 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 U.S. and Canadian, North American corporate credit, both investment grade and in high yield. And additionally, it’s widely anticipated that the Federal Reserve will continue to lower the fed funds rates in the upcoming months and quarters. And all else being equal, as the U.S. short-term interest rates decline, it will become cheaper for non-domestic bond investors to hedge that currency risk. So as those short-term rates do decline, the U.S. corporate credit bond market is going to look even more attractive to those foreign investors.