Corporate Bonds: Spreading the Wealth
Kurt Brouwer March 24th, 2009
If you want a picture of the credit crisis, you could not do much better than this one.
This chart shows the difference in spreads between corporate bonds with a given credit rating versus U.S. Treasury bonds. The legend on the left side of the chart (y-axis) is denominated in basis points (100 basis points = 1%). The legend on the bottom (x-axis) shows the spread for a given corporate rating (AAA, AA, A …).
Now, the spread is nearly 300 basis points or three percentage points. That is, if a given Treasury yields 2.70% for a 10-year bond, then a 10-year AAA corporate would have a yield of approximately 5.70%. As you can see, a couple of years ago, the spread between a AAA corporate bond and a U.S. Treasury bond was approximately 70 basis points.
That difference is translated into higher borrowing costs for corporations planning to issue new debt. And, for anyone holding corporate debt, the widening spread means the price of the bonds fell. With bonds, as yields go up, prices go down or vice versa.
The spread between Treasuries and lower-rated corporates has widened even further. The lowest rating that qualifies for ‘investment grade’ is BBB. So, BB- or B-rated bonds fall into high yield or junk bond status. For a given B-rated corporate, the yield would be approximately 17%-18% versus a Treasury at 2.70%. Yikes.
Source: ECONOMPIC DATA / Barclays
Back in 2007, we posted on this topic (see High Yield Bonds–Spreads At Historic Low Point). Back then, the spreads between Treasuries and high yield or junk corporate bonds were at a historic low or narrow point, the reverse of the situation today.
This chart below is in a slightly different format than the one above, but it illustrates that, in 2007, the spread between high yield or junk corporates was very narrow. In fact, it was about the same spread as investment grade corporates and Treasuries have today. The high yield spread today, as we saw above, is about five times what it was back in 2007:
Source: Wall Street Journal Online / JP Morgan
Historically, the best time to own junk bonds has been when the spreads were wide and subject to narrowing, which is the case now in my opinion. Over time, as the financial panic recedes, investors will almost certainly begin selling very low-yielding money market funds and Treasury Bills to seek higher yields and this should be good for the corporate bond market overall.
I believe this represents a buying opportunity for anyone who believes the end of the world is not at hand. That is, if you think this recession will end sometime later this year or early next year, then corporate bonds are likely to be fruitful investments.
Whether you look at investment grade corporates or high yield (junk) corporates, it is critical that you invest in a diversified portfolio because there will be corporate bankruptcies or defaults ahead. That is why, diversified corporate bond mutual funds or exchange traded funds (ETFs) are a suitable vehicle.
- Hedge Funds , Investing , Mutual Funds , inflation
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