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.
PTTAX invests in the investment-grade corporate bonds of companies such as Wells Fargo (WFC), Bank of America (BAC), and UBS Group (UBS). LQD invests in the high-grade corporate bonds of Credit Suisse (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, high-grade bond yields averaged 3.6%, and they rose mostly due to oil price volatility and China’s economic slowdown. In February, yields averaged a 3.6% rise, but they mostly fell as oil prices stabilized and equity markets rebounded.
In March, yields fell sharply after the dovish outlook of the Federal Reserve on the rate hike. They averaged 3.4%. In April, the downward trend in yields continued due to weak corporate results and no strong guidance by the Fed on a rate-hike. April’s yield average came in at 3.2%, the lowest so far in 2016. Yields averaged 3.3% in 2015.
Last week, investment-grade bond yields fell and ended flat on May 6, 2016, as soft economic data from Europe and China renewed concerns about a global economic slowdown. Thus, the possibility of a rate hike by the Fed in June has become grimmer.
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 S&P’s ratings 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, March, and April 2016, the OAS averaged 1.9%, 2.1%, 1.8%, and 1.6%, respectively. In 2015, the OAS averaged 1.5% in January, 1.4% in February, 1.4% in March, and 1.3% in April.
From the start of January to February 17, 2016, spreads rose consistently, indicating that investors were demanding higher yields due to increased risk on bonds. After that, the spreads saw a continuous fall. The fear of recession in the US economy faded, and the economy showed signs of improvement.
Last week, spreads rose four basis points and ended at 1.6% on May 6, 2016. Meanwhile, spreads fell 17 basis points year-to-date.
In the next article, we’ll look at the deals and volumes of investment-grade corporate bonds.