Reading the Signs: Investment-Grade Bonds Present Warning and Opportunity
US investment-grade corporate bonds look cheaper today than their lower-quality counterparts in the high-yield market. Is this the buying opportunity of a lifetime? Not exactly. A closer look reveals there’s actually method to the madness.
Both investment-grade and high-yield corporate bond valuations have declined somewhat in recent years. That’s not unusual. The US is in the late stages of a decade-long credit cycle. Interest rates are rising. At some point, rates will rise high enough to cool down the economy, reducing corporate profits.
Here’s something that is unusual: investment-grade bonds have cheapened more than high-yield ones. Usually, market stress or changing credit conditions show up in the high-yield market first. High-yield companies have more debt relative to income and higher business risk, which makes them more likely to default when growth slows.
But since January, the average option-adjusted spread (OAS) for US investment-grade bonds has risen 27%, while the OAS in the US high-yield market is just 5% higher (Display). OAS measures the extra yield that investors get over comparable government debt for taking on the credit risk of a corporate bond.
A Tale of Two Corporate Bond Markets
What’s going on? We think it has a lot to do with how the last credit cycle ended. The 2008 financial crisis posed the biggest threat to the global economy since the Great Depression. The Federal Reserve responded by slashing interest rates to record lows and pumping liquidity into the financial system.