Investment-grade corporate bond spreads have been relatively steady, but that could change soon

Published Mon, Feb 7 20221:02 PM ESTUpdated Mon, Feb 7 20223:08 PM EST

Patti Domm @in/patti-domm-9224884/@pattidomm

The stock market has slid ahead of Federal Reserve rate hikes, but investment-grade corporate bond spreads have been steadier than some expected. Gilbert Garcia, managing partner with Garcia Hamilton Associates, said spreads — that is, the difference in yields — between investment-grade corporate bonds and Treasury yields have remained relatively tight this year. Investors interpret tighter spreads as a positive sign for the economy and an indication that credit risk is declining. Conversely, spreads widen during economic tumult. Garcia said there's a disconnect between the tumbling stock market and the relatively steady investment-grade corporate bond market. He also warned that a shake-up could be around the corner for corporate bonds as the central bank dials back its economic-support measures. "As we get deeper into the tightening cycle, I think stocks are going to struggle even more, and that's when I think you'll see credit spreads widen out," Garcia said. "I could see them widening 100 to 200 basis points" before the end of the year. Changes in spreads to start 2022 On Feb. 4, the spread between the Bloomberg Barclays Investment Grade Corporate Bond Index and comparable Treasury yields was at about 107 basis points, or 1.07 percentage points, said Peter Boockvar, chief investment officer of Bleakley Advisory Group. That spread was at about 92 basis points to start the year, and it was 381 basis points during the height of the pandemic in March 2020. "They've been trading more on interest rates, than any change in credit quality, whereas high yield is trading with interest rates and initial credit quality concerns," said Boockvar. For perspective, the spread between the Bloomberg Barclays U.S. Corporate High-Yield Total Return index and Treasurys was 342 basis points on Feb. 4. It had been as wide as 1,100 basis points at the peak of the pandemic. That spread was between 350 and 450 in 2019, Boockvar added. When spreads widen, corporate bonds sell off and their yields become increasingly higher than those of Treasurys of the same duration. If they widen significantly, it could signal concerns about stress in the market, a slowing economy and weakening corporate outlooks. Boockvar said the investment-grade bond index was yielding about 2.93% Friday, compared to 2.33% at the beginning of the year. Pre-pandemic, it was at 2.84% in December 2019. The high-yield corporate bonds were yielding about 5.4% Friday, up from 4.2% at the beginning of the year, he noted. Investment-grade corporates have been in high demand, and in a period of uncertainty they can be more attractive than riskier high-yield bonds. High-yield bonds sometimes trade more closely with risk assets and can react more to moves in the stock market. Michael Contopoulos, director of fixed income at Richard Bernstein Advisors, said he is not anticipating a big move in investment-grade spreads. "The Fed is creating volatility at the moment, but if the Fed rate path becomes more certain and investors start to anticipate hikes at the pace the Fed says they're going to hike, you may see volatility come down," he said. "Earnings are strong. I don't think spreads have to widen meaningfully." But if the Fed shocks the market, "of course spreads are going to widen," Contopoulos said. The appeal of investment-grade corporates U.S. investment-grade corporate bonds have special appeal for their relative stability and higher yields in a world in which central banks kept interest rates negative and at historic lows. S & P Global recently noted that conditions in the market remain good and that default rates for even speculative high-yield bonds is quite low historically. "For now, financing conditions remain favorable, amid the continuing economic rebound, investors hunt for yield, and a recovery in credit quality. We expect the U.S. trailing 12-month speculative-grade corporate default rate to be around 2.5% by September," according to S & P Global. Demand has been solid for investment-grade corporate bonds, and companies have been taking advantage of that to issue more debt. According to Credit Flow Research, investment-grade U.S. corporate issuance in January totaled $152.1 billion, the second-highest January on record, after 2017. "I would say the bigger picture is yields are still relatively low," said Yuri Seliger, Bank of America vice president, investment-grade credit strategy. "We think that these kinds of elevated issuance levels continue into February. We're saying $110 to $120 billion of supply," Seliger said. Last February, investment-grade corporate issuance totaled $123.2 billion, a record for the month, according to Credit Flow Research. "I think it feels like issuers are pulling supply forward to try to get ahead of the Fed, ahead of higher interest rates," he said. Expectations of the Fed The Fed is expected to raise interest rates by a quarter point at its March meeting and then hike at least three more times this year. "Deals are still oversubscribed. They're clearing but they're starting to break a little bit weaker," said Garcia. He said the widening of spreads from tight levels will ultimately be a good thing. "Spreads have been tighter because there's a false sense of security that the government is going to bail you out, and I don't think that's a good investment strategy," Garcia said. "I think the government may have bailed out credit at the beginning of Covid, but ... when you have a balance sheet of $9 trillion, I don't think there's an appetite to bail out credit." He added the makeup of the market has changed. "They're very tight every which way you look at them. Whether you look at quality BBB to AAA, or whether you look at them historically. The average duration of the entire index has gone up. We're dominated by industrials that have greater event risk, and we're dominated by BBBs." BBB credits are the lowest-rated investment-grade bonds, just above high-yield debt. The iShares iBoxx $ Investment Grade Corporate Bond ETF is based on an index of dollar-denominated investment grade corporates. On Monday, it was trading close to its 52-week low. Play defense and stick with high quality For investors in investment-grade corporates, a good strategy may be to play defense and stay in the best A- or AA-rated individual bond names, Garcia said. "I would go to the biggest cap names where there's ample liquidity," he said. "The role of fixed income in the first place is it's typically meant to be a stabilizing factor in the asset allocation." Garcia said some high quality names include Walt Disney and Deere. "They may not be sexy, but at the end of the day, they're solid. They have strong balance sheets. There's ample liquidity," he said. "Their event risk is contained." The spread on a Deere bond, maturing in 10 years, was a very tight 60 basis points last week, up from 43 in June, when it was at its tightest level post-Covid. Garcia said a big portion of the new credit issued in January was in financials, like Bank of America. That's a name he favors, as well as JPMorgan, Wells Fargo and PNC. The spread on a JPMorgan 10-year maturity was 110 basis points last week. That spread was 81, at its post-Covid low in June, and 385 at its pandemic high in March 2020, Garcia noted. "Citi and Goldman are probably some of the widest spreads in the single-A space," he said, adding he holds them to bring up the average yield on his holdings. Garcia said the investment-grade market is already showing warning signs of more widening. "The offers are generally wider, one to two [basis points] every day over the last couple of days. The bids are already very squishy," he said. "It's a good indicator of what's out there and it's a precursor." Garcia also said he would stay out of long-duration bonds, like the 30-years variety, and look for opportunities in the intermediate part of the curve: the 4-year to 7-year sector. "I would not own BBBs. I would go up in credit. I'd move into single A. There's a lot of banks and brokers in that space," he said. He said intermediate duration bonds should be able to hold more of their value. "They'll be able to withstand some of this widening," he said.

A passenger wears a protective mask at the Wall Street subway station in New York, on Monday, March 30, 2020.

Michael Nagle | Bloomberg via Getty Images

The stock market has slid ahead of Federal Reserve rate hikes, but investment-grade corporate bond spreads have been steadier than some expected.