Investors looking for predictable income often make U.S. government and corporate bonds an important part of their investment portfolio. With interest rates so low, many investors consider adding lower quality, higher yielding bonds to their portfolios to increase investment income. But what are the risks associated with chasing yield?
What are credit spreads? Credit spreads measure how much the investor is being paid to take on the risk associated with the corporate bond issuer making all interest and principal payments. More specifically, a credit spread is the difference in yield between a U.S. Treasury bond and a debt security with the same maturity, but of lesser quality. So if a 10-year Treasury note is yielding 1.85 percent while a 10-year corporate bond is yielding 3.75 percent, then the corporate bond offers a spread of 1.9 percent over the Treasury note.
The chart below shows credit spreads over the course of 2016 for two types of U.S. corporate bonds: bonds deemed by ratings agencies like Moody's and Standard and Poor's to be investment grade, and lower quality, high yield bonds.
In October 2016, investors in investment grade bonds were getting about 1 percent point more than owners of U.S. government bonds with a similar maturity, while investors in high yield bonds were getting just shy of an additional 5 percentage points of interest. Relative to the beginning of the year, high yield credit spreads narrowed considerably, by more than 2 percentage points. Many financial analysts believe this narrowing was due to a strengthening in the outlook for the U.S. economy, which reduced the risk to investors of not receiving from the issuer all promised interest payments and principal.
How do credit spreads respond to changes in the economic outlook? Credit spreads have been volatile, especially high yield credit spreads, over the past 10 years (see below). During the financial crisis, for example, high yield credit spreads jumped to more than 20 percent. Investors holding high yield bonds at that time suffered substantial declines in the value of those bonds, while also taking a beating on their stocks.
In the current low interest rate environment, many investors have taken on more risk to get a higher yield on their bond portfolio. They are accepting a lower ‘risk premium’ for holding lower credit bonds, which is reflected in a narrower credit spread. But when credit spreads are so far below historical trends, it is time to ask if lower quality bonds are overpriced.
DISCLAIMER: This information is not intended to provide legal or accounting advice, or to address specific situations. Please consult with your legal or tax advisor to supplement and verify what you learn here. This is presented for informational or educational purposes only and does not constitute a recommendation to buy/sell any security investment or other product, nor is this an offer or a solicitation of an offer to buy/sell any security investment or other product. Any opinion or estimate constitutes that of the writer only, and is subject to change without notice. The above may contain information obtained from sources believed to be reliable. No guarantees are made about the accuracy or completeness of information provided. Past performance is no guarantee of future results.