What are investment-grade bonds?
Investment-grade corporate bonds are debt instruments rated BBB- and above by ratings major Standard & Poor’s. Other ratings agencies have their own scales for rating corporate bonds as investment grade. Treasuries are also considered investment grade.
Mutual funds such as the PIMCO Total Return Fund Class A (PTTAX) and ETFs such as the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) help to invest in these instruments. PTTAX invests in the investment-grade corporate bonds of companies such as Wells Fargo (WFC), Bank of America (BAC), and UBS Group (UBS).
According to the BofA Merrill Lynch US Corporate Master Effective Yield, in January 2016, yields averaged 3.6%. They rose mostly due to oil price volatility and China’s economic slowdown. In February, yields also averaged 3.6%, but they mostly fell as oil prices stabilized and the equity market rebounded.
In March, yields fell sharply after the Federal Reserve’s dovish outlook on the rate hike. They averaged 3.4%. Yields averaged 3.3% in 2015.
Last week, investment-grade bond yields rose as favorable US economic data led traders to boost wagers that inflation would climb, strengthening the Fed’s case to raise interest rates this year. Last week, high-grade bond yields rose by four basis points compared to a week earlier and ended up at 3.2% on April 22, 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 those that are rated BBB- or higher on S&P’s ratings 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 better economic conditions.
How have spreads moved?
In January, February, and March 2016, the OAS averaged 1.9%, 2.1%, and 1.8%, respectively. It averaged 1.5% in January 2015, 1.4% in February 2015, and 1.4% in March 2015.
From January until February 17, 2016, spreads rose consistently, indicating that investors were demanding higher yields due to increased risk on those bonds. After that, spreads saw continuous falls as the fear of recession in the US economy not only faded, but the economy started gaining momentum.
Last week, spreads fell by nine basis points and ended at 1.6% on April 22, 2016, the lowest level year-to-date (or YTD). Meanwhile, spreads fell by 18 basis points on a YTD basis.
In the next article, we’ll look at the deals and volumes of investment-grade corporate bonds.