Why yields on investment-grade corporate bonds continued to fall



Corporate investment-grade bonds overview in primary and secondary debt markets

In this section, we’ll be analyzing the deal flow and volumes in the primary and secondary markets for investment grade corporate bonds (LQD) or IG bonds. These bonds are rated BBB- and above, as per the Standard & Poor’s ratings system. Credit ratings are an assessment made by ratings agencies like Standard & Poor’s and Moody’s that provide an opinion on the borrower’s ability to adequately service the debt issued. In general, higher ratings imply lower credit or default risk, while lower ratings imply the opposite. Investment-grade bonds (VCIT) are deemed to have lower default risk. As a result, the rates of interest that borrowers pay are also lower, compared to high-yield bonds.

Part 7

Option Adjusted Spreads fall to the lowest level since July 24, 2007

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Effective yields on corporate bonds (as measured by the BofA Merrill Lynch U.S. Corporate Master Effective Yield Index) increased by ten basis points to 3.01% on June 6, compared to the previous week. However, effective yields are down by 32 basis points since the start of 2014, as investors have piled into safer U.S. assets like U.S. Treasuries (TLT) and IG corporate bonds. This is primarily due to geopolitical tensions abroad (notably in Russia-Ukraine). Institutional investors also exited emerging market funds (EEM) en masse in January and February, as a result of decreased market liquidity following the Fed’s taper, which led to high volatility in emerging markets. These flows made their way into safe-haven assets like U.S. Treasuries and U.S. IG corporate bonds, increasing demand and reducing yields.

Monetary policy has also continued to remain accommodative, which has kept yields low. As a reflection of the improving economy, interest rate spreads continued to trend downward in the week endeing June 6, dropping to their lowest level since July 24, 2007. The BofA Merrill Lynch U.S. Corporate Master Option-Adjusted Spread (or OAS), dropped by one basis point over the week to 110 basis points on June 6. The OAS has narrowed by 17 basis points since the start of the year.

During times of economic expansion, interest rate spreads between risky and less-risky debt (for example—U.S. Treasuries) tend to narrow. This is because businesses generally tend to do well during economic upturns, which makes the likelihood of default lower, and risk perceptions about firms decline. As a result, the required rate of return on riskier debt, in comparison to safer debt, also tends to decrease, reducing spreads.

Continue reading the next section of this series to access an analysis of the numbers and prominent debt issues, including Wells Fargo (WFC), Baidu, AT&T, and Verizon.



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