Corporate Bond Risk Measures Nearing All-time Highs

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By Mike Sanders, CFA, FRM, Head of Fixed Income, Portfolio Manager

As if low interest rates and tight credit spreads weren’t enough to challenge fixed income investors in this market, the pool of investment grade corporate bonds seems to be getting riskier as well. The Bloomberg U.S. Corporate Index, which measures the investment grade, fixed-rate, taxable corporate bond market, and serves as a proxy for the U.S. credit market, now has an average duration of 8.78 years – nearly the longest it has ever been (98th percentile)1.

Duration bloomberg us corp Source: Bloomberg

Further, because of low yields/spreads and long duration, break-even spreads/yields have fallen to the sub-5th percentiles1. The current break-even yield for the index is 22.64 basis points (bps), which means yields must only increase by that amount to negate current yield in the portfolio and earn 0% on the investment. When comparing to spreads, the index needs only to widen by 9.88 bps to wipe out the entire carry advantage, or expected premium for holding bonds with credit risk. For historical context, the average yields and spreads needed to break even over the last 20 years are 65.07 bps and 23.36 bps, respectfully. We believe this makes short duration, high-quality bonds especially attractive now.

Break even bps Source: Bloomberg

Not forgotten in our analysis of the corporate bond index is the fact that these lowest quality investment grade bonds, or those rated BBB, now make up 51% of the index, compared with 34% twenty years ago.

Of course, bonds still play an important diversification and income role in a portfolio and an uptick in risk won’t spark an exodus of the asset class, but investors would be wise to check in on their investments and examine the makeup of their bond allocation.

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1 Source: Bloomberg

Bonds are subject to certain risks including interest-rate risk, credit risk and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds. In a low-interest environment, there may be less opportunity for price appreciation.

Bond Spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, and risk, calculated by deducting the yield of one instrument from another.

Credit spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality.

Yield to worst (YTW) is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting.

Option-adjusted spread (OAS) is a measure of yield spread that accounts for embedded call options in the valuation of bonds.

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows.

The Bloomberg U.S. Corporate Bond Index is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more. You cannot invest directly in an index.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only, and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance.

One basis point equals 0.01% or 1/100th of a percent.