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Why Credit Spreads Expanded Last Year

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This flight to quality movement also impacted credit spreads, which widened for high yield corporate bonds, negatively impacting the returns of bonds in that sector.

Why Credit Spreads Expanded Last Year

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Market Realist – High yield bonds underperform when the global economy is slowing.

Investors consider US Treasury bonds (TLT)(IEF) to be very safe because the full faith and credit of the US government back them. Thus, investors pay a premium in the form of lower yields to purchase Treasuries. 

On the other hand, investors believe that high yield bonds, or junk bonds, (HYG)(JNK) are quite uncertain because these bonds come with credit risks. While Treasuries have virtually no default risks whatsoever, junk bonds do. To attract investors, junk bonds have to offer much higher yields.

High yield bond prices are cyclical in nature. When the economy and the credit markets are improving, high yield bonds perform well. Likewise, when the economy and the credit markets are deteriorating, high yield bonds crash as the probability of default heightens. Therefore, these bonds tend to be quite volatile. A junk bond has a rating below BBB on Standard & Poor’s or a rating below Baa on Moody’s.

The graph above compares the yield on the BofA Merrill Lynch US High Yield CCC or Below with the yield on BofA Merrill Lynch US corporate bonds rated A by Standard and Poor’s. During the Great Recession, the former crashed, yielding as high as 42%. Meanwhile, corporate bonds rated A, which fall within investment grade (LQD), were more stable. This is because such bonds are issued by companies like Apple (AAPL), which have robust cash flows to withstand shocks.

Similarly, the global slowdown and the slump in oil (USO) prices caused credit spreads between junk bonds and Treasuries to increase. A good chunk of the high yield bond issuers belongs to the energy sector. Their fortunes are heavily tied to oil prices.

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