Caution as Spreads Grind Tighter
Yields look attractive compared to six months ago, but spreads have discounted the potential for pro-growth fiscal policies.
Optimism overtook the investment-grade corporate bond market in 2016. Demand for yield facilitated $1.2 trillion of capital raising by U.S. investment-grade corporate bond issuers ($652 billion on a net basis), surpassing 2015’s record by almost $15 billion. By year end, spreads in the energy sector had retraced to their tightest level since November 2014, when West Texas Intermediate spot oil prices averaged $77 per barrel. A positive 2017 earnings outlook fueled the rally more broadly, with average index spreads ending the year at their tightest level since March 2015, as markets priced in anticipated pro-growth policy changes. Yields have risen against tightening spreads as the market has priced in anticipated policy changes by the incoming administration into benchmark Treasury yields. Spreads appear tight, but yields look more attractive today than in the middle of 2016.
Another Year of Record Issuance
Demand for yield facilitated $1.2 trillion of capital raising by U.S. investment-grade corporate bond issuers ($652 billion on a net basis), surpassing 2015’s record by almost $15 billion.
Source: JP Morgan, Guggenheim Investments. Data as of 12.31.2016.
Investment-grade corporate bond spreads absorbed some of the increase in Treasury yields, with spreads tightening by 15 basis points quarter over quarter to 123 basis points. The biggest moves once again stemmed from spreads tightening in energy and basic materials. The backup in rates caused the Bloomberg Barclays Investment-Grade Corporate Bond index to suffer a loss of 2.8 percent during the fourth quarter of 2016, breaking a streak of three consecutive positive quarterly returns. However, investment-grade corporate bonds outperformed duration-matched Treasurys by 0.8 percent.
The prolonged period of low interest rates has facilitated investor willingness to accept weaker structural protections in exchange for yield. While this trend has existed for at least a couple of years already, it is beginning to garner real investor attention. The combination of weaker structures and hope-driven tightening in spreads heightens our concerns. We believe spreads can grind tighter from current levels, but weaker structures and increased leverage are currently laying the groundwork for future downgrades. We continue to focus on higher quality and timelier relative-value trades until spreads widen to compensate investors appropriately for lower-quality credits and weaker structural protections.
Market Absorbs Some of the Rate Backup
Treasury yields have risen by 104 basis points since bottoming at 1.36 percent to reach 2.40 percent as of Jan. 23. Investmentgrade corporate bond yields have followed Treasury yields higher, but to a lesser extent, demonstrating their capacity to absorb some of the backup in rates. Investment-grade bond yields bottomed out at 2.75 percent in July 2016, and were trading at 3.30 percent as of Jan. 23, an increase of 55 basis points.
Source: Bloomberg Barclays Indices, Guggenheim Investments. Data as of 1.23.2017. Note: Yield to Worst is for the Bloomberg Barclays Corporate Investment Grade index.
—Jeffrey Carefoot, CFA, Senior Managing Director; Justin Takata, Director
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