What are investment-grade bonds?
Investment-grade corporate bonds are debt instruments rated BBB- and above by rating major Standard & Poor’s. Other rating agencies have their own scale of rating a corporate bond as investment-grade. Treasuries are also considered investment-grade.
Mutual funds like the Vanguard Total Bond Market Index Fund – Investor Class (VBMFX) help you to invest in these instruments. The VBMFX invests in investment-grade corporate bonds of companies such as Apple (AAPL), Verizon (VZ), Goldman Sachs (GS), Cisco Systems (CSCO), and Home Depot (HD).
According to the BofA Merrill Lynch US Corporate Master Effective Yield, yields had ranged between 2.8% and 3.7% in 2015. In January 2016, yields averaged 3.6%. They rose mostly due to oil price volatility and China’s economic slowdown. Despite equity market volatility and softening credit conditions, investment-grade bond yields rose five basis points week-over-week and ended at 3.7% on February 12, 2016.
Meaning and importance of spreads
The BofA Merrill Lynch Option-Adjusted Spread (or OAS) measures the average difference in yields between investment-grade bonds and Treasuries. Securities selected for calculating this spread are the ones that are rated BBB- or higher on the S&P rating scale.
If spreads are rising or widening, credit conditions can be assumed to be worsening. Spreads also widen when growth is slow and economic conditions are worsening. Conversely, falling or tightening spreads coincide with faster growth and with better economic conditions.
How have spreads moved?
In 2015, spreads had ranged between 1.3%-1.8%. In January 2016, the OAS averaged 1.9%.
The widening of spreads means that investors are demanding higher yields because the risks on those bonds have increased, which raises doubts about the health of the economy and increases company’s costs to raise debt from the market. In turn, this impacts the overall supply of credit and economic growth. On February 11, spreads touched 2.2%, which is the highest since June 20, 2012. Spreads rose by 11 basis points from the previous week and ended at 2.2% on February 12, 2016. Meanwhile, spreads are up 76 basis points on a year-to-date basis.
In the next article, we will look at the deals and volumes of investment-grade corporate bonds.