What are investment-grade bonds?
Investment-grade corporate bonds are debt instruments rated BBB- and above by 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 (MFs) like the PIMCO Total Return Fund Class A (PTTAX) and ETFs such as the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) help you to invest in these instruments. PTTAX invests in investment-grade corporate bonds of companies such as Wells Fargo and Company (WFC), Bank of America (BAC), and UBS Group AG (UBS), while LQD invests in high-grade corporate bonds of Credit Suisse AG (CS), Verizon Communications (VZ), Goldman Sachs (GS), Apple (AAPL), and General Electric (GE).
According to the BofA Merrill Lynch US Corporate Master Effective Yield, in January 2016, yields averaged 3.62%. Yields rose mostly due to oil price volatility and China’s economic slowdown. In February, yields also averaged 3.62%, but they were mostly down as oil prices stabilized and the equity market rebounded. In March, yields fell sharply and averaged 3.44% after the Fed gave a dovish outlook for the next interest rate hike.
In April, the downward trend in yields continued due to weak corporate results and a lack of strong guidance by the Fed on the next rate hike. April’s average came in at 3.15%—the lowest so far in 2016. Yields averaged 3.25% in 2015.
Last week, investment-grade bond yields fell on soft economic growth data, disappointing quarterly results, and hope that the federal funds rate hike may not happen soon due to the global economic slowdown. High-grade bond yields fell 9 basis points on a week-over-week basis and ended at 3.06% on April 29. This was the lowest yield so far in 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 rated BBB- or higher on Standard & Poor’s rating 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, March, and April 2016, the OAS averaged 1.88%, 2.13%, 1.83%, and 1.62%, respectively. In 2015, spreads averaged 1.50% in January, 1.43% in February, 1.35% in March, and 1.33% in April.
From January to February 17, spreads rose consistently, which indicates that investors were demanding higher yields because the risk on those bonds had increased. After that, spreads saw a continuous decline, as fear of a recession in the US economy faded, and the economy even showed signs of improvement.
In the week ending April 29, spreads fell 3 basis points and ended at 1.52%—the lowest level YTD (year-to-date). Spreads have fallen 21 basis points YTD.
In the next article in this series, we’ll look at the deals and volumes of investment-grade corporate bonds.