Bond Concepts by Madison Investments

After suffering for nearly fifteen years under the Federal Reserve’s Zero Interest Rate Policy (ZIRP), fixed income investors have welcomed the return of yield to the domestic bond markets. The available yield comes from two primary sources: the level of interest rates, as indicated by the U.S. Treasury yield curve, and the level of spreads, which represents the additional yield available for owning something other than a Treasury. We know the Fed helped engineer higher Treasury rates, a move they are just beginning to reverse, but what about the overall spread environment?

 

What Does Spread Mean?

In the fixed income world, we price nearly all risk assets at a “spread” to a maturity or duration matched U.S. Treasury issue. At least for the foreseeable future, markets worldwide consider U.S. Treasuries to be the safest and most liquid asset readily available. Therefore, when buying a bond other than a Treasury, investors require additional yield, a “spread over Treasuries,” for taking additional risk. The spread is generally quoted in hundredths of a percent, also known as basis points, over a similar Treasury. For example, a five-year corporate bond might be quoted at 1.00% or 100 basis points over the current five-year Treasury bond.

 

What Risks Are Bond Holders Paid a Spread for Taking?

Generally, there are three primary risks bond investors take when stepping away from a Treasury: credit, structure, and liquidity risk. Credit risk is the possibility that the issuer fails to make timely principal or interest payments, often measured in a bond’s credit rating. Structure risk refers to the potential unpredictability of a bond’s cash flows, for example, a call feature in a bond or prepayments in a mortgage or asset-backed security. We use option math (which could be its own white paper – that most of you would not want to read) to calculate an Option Adjusted Spread to measure structure risk. Liquidity risk encompasses how quickly and at what discount a bond can be converted into cash, often measured by a bond’s quoted bid/ask spread.

 

What are the Spread Sectors in the Domestic Bond Market?

There are four primary spread sectors available to investors: corporate bonds (investment grade and high yield), mortgage-backed securities (MBS), asset-backed securities (ABS), and commercial mortgage-backed securities (CMBS). These are consistent with most indices that categorize the domestic bond markets.

 

How Does Spread Affect My Portfolio’s Performance?

Spread affects total return in two ways. First, it allows an investor to lock in a yield (income) higher than an ultra-safe Treasury. Absent a default, an investor will earn extra yield until the bond matures. The second is less obvious. As spreads change, which they do constantly, they expose the investor to potential capital appreciation/ depreciation relative to that Treasury. When markets are confident and liquid, and the economic outlook is positive, spreads tend to tighten, resulting in paper gains relative to that Treasury used to measure the initial spread. When the markets turn less confident and liquid, or the outlook darkens, spreads tend to widen, resulting in relative underperformance. This tightening and widening of spreads will affect a bond’s market value until it matures.

 

Risk vs Reward – How it Works

Most market participants would characterize a spread sector as fairly priced when trading near the median of its long-term spread history. When spreads are at their extremes, the risk-reward relationship tends to become asymmetric. Spreads are relatively cheap when near their wider levels. While spreads could widen further, the historical risk-reward relationship suggests more upside potential than downside risk, meaning investors are likely well-compensated for taking that risk. On the other hand, we would consider spreads rich when trading near historically tight levels. While there is a chance they could continue to tighten, the downside risk is greater than the upside potential, especially when investors are being paid relatively little for taking that risk.

Current Valuations by Sector Current Valuations by Sector

Impact of Quality and Liquidity

As the previous chart shows, pricing across most spread sectors looks rich, corporate spreads particularly so. With spreads in the credit sectors at or near their historic lows, the risk/reward relationship is asymmetric - more downside risk than upside potential. However, the risk is much greater in lower quality/less liquid sectors. During a market correction, this manifested in a widening of the relative spreads. 

The chart below illustrates the historical spread difference between A-AAA corporate bonds, lower-quality BBB, and high-yield bonds. During periods of market stress, spreads on lower-quality bonds will tend to gap out relative to higher-quality issues, resulting in relative underperformance.
 

Historical Spread Difference Historical Spread Difference: A-AAA Corporates vs BBB and High Yield

How has this played out in the past? Let’s look at three of the more volatile spread-widening events in the last 25 years: the tech bubble, the Great Financial Crisis, and COVID. Each was preceded by a period of relative market calm; then, an unexpected shock sent spread wider. When that happens, the gap in relative performance can be extreme.

Corporate Bond Historical Spreads Corporate Bond Historical Spreads
Corporate Bond Recession

Don’t misunderstand; we are not implying a major spread-widening event is imminent – by their very nature, those are not predictable. But it wouldn’t take a financial crisis or pandemic to see a meaningful divergence in performance across quality sectors of the market. As the chart below shows, there appears to be very little room for relative spreads to tighten (outperformance) and plenty of room for them to widen (underperformance).

Historical Spread Range Historical Spread Range

Conclusion

Spread sectors remain an important part of a diversified bond portfolio, as they offer an opportunity to increase the yield and, therefore, income available. Investors should, however, understand the potential exposure to positive and negative relative price performance that comes with the risk. We do not advocate avoiding spread sectors altogether today. In fact, for much of the past 15 years, as the Federal Reserve pursued its Zero Interest Rate Policy, investors were essentially forced to accept more risk than they might otherwise tolerate. 

Currently, spread sectors are near historically tight levels. It is possible that spreads could stay here for some time or even tighten modestly. But in an overall higher yielding environment, conservative investors shouldn’t feel compelled to take on excessive spread risk in order to get attractive yield into their portfolios. 

Given these dynamics, an active manager can play a crucial role by continuously monitoring spreads across sectors, quality levels, and maturities to help optimize the balance of risk and return. We recommend that investors evaluate their current spread exposures to ensure they are comfortable with the risks and rewards and consider active management to navigate today’s tight spread environment.


BOND CONCEPTS BY MADISON INVESTMENTS

Learn the nuances of fixed income investing, including the risks, opportunities, and investment styles.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”). MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

Any performance data shown represents past performance. Past performance is no guarantee of future results.

Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of, or guaranteed by, any financial institution. Investment returns and principal value will fluctuate.

This website is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

In addition to the ongoing market risk applicable to portfolio securities, bonds are subject to interest rate risk, credit risk and inflation risk. When interest rates rise, bond prices fall; generally, the longer a bond’s maturity, the more sensitive it is to this risk. Credit risk is the possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. Bonds may also be subject to call risk, which allows the issuer to retain the right to redeem the debt, fully or partially, before the scheduled maturity date. Proceeds from sales prior to maturity may be more or less than originally invested due to changes in market conditions or changes in the credit quality of the issuer.

Diversification does not assure a profit or protect against loss in a declining market.

Also known as junk bonds, high-yield bonds are bonds issued by companies that are considered to be at a greater risk of failing to make interest and principal payments on schedule.

Bond ratings are based on information provided by various ratings agencies such as S&P or Moody’s Investor Service. They are for informational purposes only and do not predict the probability of default.

INDEX DEFINITIONS
Indices are unmanaged. An investor cannot directly invest 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.

ICE BofA AAA-A US Corporate Index: tracks the performance of US dollar-denominated investment-grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a rating between A and AAA (based on an average of Moody’s, S&P and Fitch).

ICE BofA BBB US Corporate Index: tracks the performance of US dollar denominated investment grade rated corporate debt publicly issued in the US domestic market. This subset includes all securities with a given investment grade rating BBB (based on an average of Moody’s, S&P and Fitch).

ICE BofA BB-B US High Yield Index: tracks the performance of US dollar-denominated below investment-grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a rating between B and BB (based on an average of Moody’s, S&P and Fitch)

DEFINITIONS
Duration: 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.

Option-adjusted spread (OAS): is the yield spread of a bond over a risk-free rate, usually a similar maturity Treasury, adjusted for the bond’s embedded options. It reflects the additional return investors require to compensate for the risks and potential changes in cash flows due to options such as a bond’s callability.

Basis Point: one-hundredth of a percent.

Yield Curve: a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. There are three main types of yield curve shapes: normal (upward0sloping curve), inverted (downward-sloping curve), and flat.

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