Q: How can you determine if corporate bonds are cheap or expensive? A: By looking at the spreads to Treasury bonds, relative to the state of the economy. Why you should care: Corporate bonds look reasonably priced compared with Treasuries.
Last week we argued that corporate bonds look reasonably priced and appear cheap relative to Treasuries. Now, I want to address the logical follow-up question: How do you know what a fair price is for corporate bonds?
Market Realist – Bond yields have increased recently.
The graph above compares the yield on the ten-year US Treasury (IEF), corporate bonds rated AA, and corporate bonds rated CCC or below.
The ten-year Treasury currently stands at 2.1%. On February 2, it was yielding only 1.68%. The sudden back-up in yields was due to improving jobs data and hopes that the situation in Greece (GREK) would improve.
During the financial crisis, high yield bonds (HYG)(JNK) had skyrocketed to ~45%. However, the higher-quality corporate bonds or investment-grade corporate bonds (LQD) were sturdier during that period.
Since August of last year, high yield bond yields, or junk bond yields, have started picking up. This is because oil (USO) prices plummeted. Since many high yield bond issuers belong to the energy sector, this caused investors to move out of high yield bonds. They sensed the start of a default cycle because low oil prices hurt oil companies’ bottom lines.
In the mid 2000s, when the economy was robust, the spread between corporate bond yields and Treasury yields was very low. The rest of this series explains what drives the spread between the yields of Treasury bonds and corporate bonds.