Thoughts On Corporate Spreads

I have often had discussions towards the end of 2018 and into 2019 on the topic of the corporate bond market and trying to determine how much risk is in this asset class is at the moment. Historically, holding investment grade corporate bonds has been a relatively safe investment, with an average default rate over a 5-year period of less than 1% (just 0.91% from 1970-2017, per Moody’s). Some folks are speculating that due to a combination of factors (increased debts levels, the sheer amount of BBB rated bonds, the potential for a recession, potentially increasing refinancing costs, etc.) that corporate bonds could be the next black eye experienced by the market. But what is the market actually telling us?

One of the best indicators of how much risk the market perceives there to be in a corporate bond is its spread. A spread is the difference between a bond’s yield and the yield on its benchmark (i.e. corresponding Treasury). The wider (higher) the spread, the more yield the market is demanding for this bond versus a corresponding security with little perceived credit risk. Simply put, the wider the spread, the riskier the bond. The graph below plots the range of spreads for corporate sectors over the past year (blue line) along with the current spread of each sector (red diamond). If all of the red diamonds were at the very top of the blue lines, this would be telling us that the market thinks that corporate bonds are the riskiest they have been over the past year. But as you can see, current spread levels are all near the past year’s mid-range point.

Taking a step back, the Bloomberg screenshot below shows Investment Grade corporate spreads for the past 5 years. There has been quite a bit of movement, but looking at the current level versus the average over this time frame, we see that spread levels are almost exactly at their 5-year average (122.201 as of Friday afternoon versus an average of 122.428). Again, a similar story to the first graph… not the tightest they have been but also nowhere near the widest.

Source: Bloomberg LP – Option Adjusted Spread of the US Dollar Investment Grade All Cash Bonds sector, as of 2/22/19

The market can’t predict the future any better than any one investor or commentator, but with the fundamental belief that markets are efficient, these current spread levels are an aggregate assessment of risk using all available information at the market’s disposal. Current spread levels are sharply lower than they were just a couple of months ago and are not currently indicating any sort of warning sign that the corporate bond market is about to have a meltdown. Although we pay attention to the current landscape as well as your current situation and risk tolerance and position accordingly, you can benefit from the relatively attractive yields that corporate bonds are providing.