Spread Levels Matter

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.

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.

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.

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).

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.