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High-Grade Bond Yields and Spreads Fall as US Economy Improves

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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) and ETFs such as the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) help you to invest in these instruments. They invest in investment-grade corporate bonds of companies such as Apple (AAPL), Verizon (VZ), Goldman Sachs (GS), Cisco Systems (CSCO), and Home Depot (HD).
High-Grade Bond Yields and Spreads Fall as US Economy Improves

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Yield movement

According to the BofA Merrill Lynch US Corporate Master Effective Yield, in January 2016, high-grade bond yields had averaged 3.6%, and they had risen mostly due to oil price volatility and China’s economic slowdown. In February, yields averaged 3.6%, but they were mostly down as oil prices stabilized and the equity market rebounded. In 2015, yields had ranged between 2.8% and 3.7%.

Last week, investment-grade bond yields fell sharply after Janet Yellen, the chair of the Federal Reserve, released a relatively dovish statement and lowered the Fed’s forecasts for further interest rate hikes through 2018 in the wake of the global economic slowdown and plunging oil prices. The yields and spreads in the US stand at a level where investors are inclined towards investing in US corporate bonds despite the decline in yields, following the Federal Reserve’s meeting last week. The yields ended at 3.4% on March 18, 2016, 20 basis points lower than the previous week.

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 rating scale of the S&P.

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 January and February 2016, the OAS had averaged 1.9% and 2.1%, respectively. In 2015, spreads had ranged between 1.3% and 1.8%.

In January and until February 17, spreads rose consistently, which means that investors were demanding higher yields because the risk on those bonds had increased. But after that, the fear of recession in the US economy has faded away on the backdrop of improved economic indicators and stimulus measures in Japan, Europe, and China.

Last week, spreads were down, and they ended at 1.8% on March 18, nine basis points lower than the previous week. Meanwhile, spreads are up by just three basis points year-to-date.

In the next article, we will look at the deals and volumes of investment-grade corporate bonds.

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