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 (or MFs) 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 Communications (VZ), Goldman Sachs (GS), Cisco Systems (CSCO), and Home Depot (HD).
According to the BofA Merrill Lynch US Corporate Master Effective Yield, in January 2016, yields had averaged 3.6%, and they had risen mostly due to oil price volatility and China’s economic slowdown. In February also, yields averaged 3.6%, but they were mostly down as oil prices stabilized and the equity market rebounded. In January and February 2015, yields averaged 3.01% and 3.05%, respectively.
Last week, investment-grade bond yields fell as the Federal Reserve is worrying more about the global economic downturn, which makes the probability of a rate hike in April look grim. Thus, the high-grade bond yields fell sharply by 13 basis points and ended at 3.2% on April 1, 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 rating scale of 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. It has averaged 1.5% in January 2015 and 1.4% in February 2015.
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 spreads saw a continuous decline as the fear of recession in the US economy faded, and the economy started gaining momentum.
The spreads touched 1.7% on April 1, the lowest they’ve been since December 11, 2015. They were lower by four basis points as compared to the previous week. Meanwhile, spreads are down by four basis points on a YTD basis.
In the next article, we will look at the deals and volumes of investment-grade corporate bonds.