Don’t be Fooled by the Spread

Here is a quiz for our readers. Currently, credit spreads on 1-10 year corporate bonds are 81 basis points, meaning, yields on these bonds are 0.81% higher than on comparable Treasury bonds. Will these corporate bonds outperform Treasury bonds by roughly 0.81% over the next year?

If history is our guide, the answer is actually no. In fact, on average, corporate bonds have underperformed Treasuries (negative excess returns) by about 1% during similar historical periods despite their higher starting yields. Why is that? This article will explain the dynamics of investing in corporate bonds and how to avoid being fooled by the spread.

Why Corporate Bonds Yield More than Treasuries

Investors demand higher yields on corporate bonds because of the inherent additional risk. Corporate borrowers can default or be downgraded, whereas Treasuries are thought to be default-risk-free. This difference between yields on corporate bonds and Treasuries is known as “credit spread.”

Credit spreads are not stationary. They are continuously moving, just like stock prices. Credit spreads widen (increase) during market sell-offs, and spreads tighten (decrease) during market rallies. Tighter spreads mean investors expect lower default and downgrade risk, but corporate bonds offer less additional yield. Wider spreads mean there is more expected risk alongside higher yields.

The Current Credit Environment

Currently, credit spreads are near historic lows. At 0.81%, 1-10 year spreads are in the tightest decile over the last 25 years. The chart below illustrates the change in investment grade credit spreads over the last 25 years.

What to Expect from Today’s Corporate Bond Market

Historically, these tight spread levels do not bode well for excess returns of corporate bonds. The corresponding chart details starting credit spreads and forward 12-month excess returns. It is clear that wide starting spreads correspond with higher corporate bond returns, and vice versa. As an example, during the Lehman Brothers’ bankruptcy period in 2009, credit spreads hit 600 basis points. Over the forward 12 months, corporate bonds outperformed Treasuries by over 20%.

From today’s spread levels of 81 basis points, the implied excess return is actually around -1%. Does that mean you should have no investment-grade corporates in your portfolio? Not necessarily. However, it does call for selectivity.

Longer Corporate Bonds Carry Higher Risk

The following table compares risk and return metrics for different corporate bond maturities. The longer a bond’s maturity, the greater the yield and the greater the uncertainty about excess returns. Whereas, shorter bonds have observed more frequent but more controlled levels of risk and excess returns.

For instance, 1-3 year corporate bonds have outperformed Treasuries 82% of the time, with median 12-month excess returns of 0.72%. While, 7-10 year corporate bonds have a median 12-month excess return of 0.84%, a mere 0.12% higher, but have only outperformed just 58% of the time. Undeniably, there is greater risk associated with longer maturities.

Indexes represented by: ICE BofA US Corp 1-3yr, ICE BofA US Corp 3-5yr, ICE BofA US Corp 5-7yr, ICE BofA US Corp 7-10yr

Time period: 12/31/1996 – 02/28/2021

Sources: Bloomberg, BofA Merrill Lynch

Conclusion

How should investors respond to the current environment? Based on history:

• Spreads are relatively tight.
• Future excess returns tend to be negative when spreads get to the tightest decile.
• Longer dated maturities are historically more volatile.

We do not foresee a damaging default cycle; however, we believe future excess returns might be subdued. The environment calls for patience and discipline. Shorter corporate bonds may be a better place to allocate capital currently. We are taking steps to respond in client portfolios and will diligently monitor positioning for opportunities to fulfill our mission of maximizing returns subject to prudent risk management.

*OAS: Option Adjusted Spread, measures the difference in yield between an option-embedded bond and the risk-free rate.