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Why High-Grade Bond Yields and Spreads Fell in 1Q16

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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 (or S&P). Other rating agencies have their own scales for rating corporate bonds as investment-grade. Treasuries are also considered investment-grade.

Mutual funds such as the Vanguard Total Bond Market Index Fund Investor Class (VBMFX) and ETFs such as the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) can help you to invest in these instruments. They invest in the investment-grade corporate bonds of companies such as Apple (AAPL), Verizon Communications (VZ), Goldman Sachs (GS), Cisco Systems (CSCO), and Home Depot (HD).

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Yield movement

According to the Bank of America Merrill Lynch US Corporate Master Effective Yield, in January 2016, high-grade bond yields averaged 3.6%. They rose mostly due to oil price volatility and China’s economic slowdown.

In February 2016, yields also averaged 3.6%, but they mostly fell as oil prices stabilized and the equity market rebounded. In March, yields fell. They averaged 3.4%, mainly due to dovish comments on the rate hike by the Federal Reserve.

2016 started with rising yields, which continued until mid-February. Following that, yields fell as the prospects of a rate hike in the near term became grim amid oil woes and the global economic slowdown. In 1Q16, investment-grade bond yields fell sharply by 47 basis points. They ended up at 3.2% on March 31, 2016.

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Meaning and importance of spreads

The Bank of America 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 rating scale.

If spreads are rising or widening, credit conditions are 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, which meant that investors were demanding higher yields due to increased risk. After that, the spreads saw a continuous fall as the US economy stabilized and the fear of recession faded.

Spreads touched 1.7% on March 31, 2016, the lowest level year-to-date. They ended up three basis points lower than in the previous quarter.

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

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