The past five months have been absolutely brutal for investors buying investment grade bonds. Here’s the details…
The US stock market is on fire.
The American economy is clipping along at the best pace in a long while. Financial conditions are still easy. Not surprisingly, high-yield bond spreads are within spitting distance of recent tights (lows).
This is all to be expected in an environment of economic expansion.
Investment-grade not playing ball
As a macro guy, there is nothing unexplained with this picture. But I must admit, I don’t follow the day-to-day movements of different parts of the bond market as much as I should. Luckily, I have friends at credit shops who recently brought to my attention the divergence between investment-grade OAS (Option Adjusted Spread) and high-yield OAS. For those not familiar with OAS, think about it as the spread you earn on top of the risk-free government rate for taking the credit risk of a corporate bond. For example, if government bonds yield 2.25% and the comparable high-yield index yields 5.50%, then the OAS is 3.25%.
Obviously investment-grade bonds (those with a credit rate BBB- or higher) will typically trade at a lower OAS than high-yield bonds (those rated below BBB-). But generally you would expect the two indexes to follow each other relatively closely. And in fact, stresses often show up first in the high-yield market.
Yet, something unusual is happening in investment-grade bonds. Even though most other risk indexes are well bid, investment-grade bonds are struggling.
Here are the two different indexes since 2010.
Let’s drill in on the action over the past year and a half.
The past five months have been brutal to investment-grade credit investors. IG OAS has risen from 95 bps in late January, to 140 bps today. This is a big move for investment-grade bonds. it is an especially big move considering the fact that most other risk assets are not following suit.
In fact, if we look at the ratio of high-yield OAS to investment-grade OAS, we are sitting at the lowest level since 2009 (chart from Barclays):
Something unusual is happening.
Is the investment-grade sell-off overdone? Or is high-yield due for some catch-up on the downside?
I don’t have any answers, but it is interesting that investment-grade bonds are having such a difficult half-year. Maybe we look back at this period and say it was a great buying opportunity. But maybe we look back and say, the investment-grade bond market knew something way sooner than the rest of us.
Thanks for reading,
PS: If you haven’t had a chance, don’t forget to check out East West’s latest research piece – U.S. Banks Poised to Outperform Canadian Counterparts.