Corporate bond spreads have rallied and have not been this tight since 2014; to find tighter spreads you have to go back to before the financial crisis. We define corporate spreads as the additional yield you receive over a comparable treasury. That is, if you purchase an average 10-year “A” quality corporate bond, today you earn 80 bps over a ten-year U.S. Treasury. We have had quite the rally in corporate spreads over the last 18 months, and today’s 80 bps is a pretty thin margin.
Should we be getting worried corporate bonds are too rich and the rally may end?
It depends. Right now, spreads are tight and trending tighter as the U.S. economy continues to grow, inflation remains low, there is lots of liquidity in the financial system, Fed hikes are not a concern, the equity markets are setting new highs, corporate earnings are strong, and corporate leverage is elevated but not a concern. In a world of very low yields even 80 bps looks great!
Yet spreads will not tighten forever. While we could easily set new tights, history shows we have more scope to widen than tighten when the economy slows, corporate earnings start to flag or investor sentiment turns sour – for whatever reason.
We keep our discipline and are ready when trends turn. We generally take our credit exposure in the front end of the curve, shy away from cyclical story credits, prefer the best operators in an industry and, with spreads so tight, upgrade when the yield give-up is minimal.
So, let’s enjoy rally time while it lasts!
Source: Barclays Capital