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 to be 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).
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 again 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 fell due to soft economic data. They touched 3.1% on April 15, 2016, the lowest level since June 1, 2015. Meanwhile, high-grade bond yields fell by three basis points week-over-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 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. 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 to February 17, 2016, spreads rose consistently, indicating that investors were demanding higher yields due to increased risk on those bonds. Following this rise, the spreads saw a continuous fall. Fear of a recession in the US economy has not only faded, but the economy has also started gaining momentum.
Spreads touched 1.6% on April 14, 2016, the lowest level year-to-date (or YTD). Last week, spreads fell by six basis points. Meanwhile, spreads are down by nine basis points YTD.
In the next article, we’ll look at the deals and volumes of investment-grade corporate bonds.