What a difference a few months make. Last July the spread between investment-grade U.S. corporate bonds and comparable Treasuries hit a seven-year low of just below 100 basis points, as measured by Bank of America Merrill Lynch bond indexes. By December 16 the spread had climbed to a one-year high of 151 basis points; it now stands at 153 basis points.
The 50 percent–plus jump in the spread between Treasuries and investment-grade corporate bonds stems from several factors, including plunging oil prices, rising market volatility, heavy corporate issuance and the stronger dollar. “When there’s turmoil in financial markets, investors become more apprehensive and demand a greater risk premium for a given level of risk,” says Martin Fridson, a veteran Wall Street credit analyst who is chief investment officer at Lehmann Livian Fridson Advisors, a money management firm based in New York. Market volatility accounts for 55 percent of the movement in the spread, adds Fridson.
The recent drop in oil prices — down 56 percent since late June — has had a major impact on the spreads of energy companies’ corporate bonds, which account for 14 percent of the Bank of America Merrill Lynch investment-grade corporate bond index. The spread for the energy sector widened by 40 basis points in December alone, versus an increase of just 5 basis points for nonenergy corporate paper. (Overall, the spread over Treasuries widened by 9 basis points last month.)
“A lot of investors are worried about risk assumptions because of unknowns, such as energy prices,” says Jody Lurie, corporate credit analyst at Janney Montgomery Scott in Philadelphia. The Chicago Board Options Exchange Volatility index, also known as the VIX, which measures the expected volatility of the S&P 500 index, closed December at 19.2 percent, its highest month-end level of the year. It now stands at 20.16.
U.S. corporations issued a record $1.19 trillion in investment-grade bonds in 2014, with activity picking up in the last few months of the year. (September 2014 was the second-highest month for U.S. investment-grade bond issuance ever.) The increase in supply helped push the premium rates even higher above the prevailing interest rate, says Ashish Shah, head of global credit at AllianceBernstein in New York.
The growing strength of the dollar against other developed-market currencies, including a seven-year high against the yen, has had negative ramifications for investment-grade corporate bonds, Shah says. “The Japanese are large investors in dollar-spread products,” he explains. “They have done it hedged, and a strengthening dollar leads foreign investors to be net sellers of U.S. bonds when they’re hedged.” According to Lurie, weak data out of Europe have also deterred some investors from U.S. investment-grade corporates because of fear of contagion.
But Fridson doesn’t see the macroeconomy as much of a factor in the spread widening, as GDP growth averaged 4.8 percent annualized in the second and third quarters of last year. In any case, the spread widening may shrink corporate issuance — but not by much. “If yields rise, companies aren’t willing to issue if they think lower rates are coming,” Lurie says. “At the same time, companies are fearful low rates will dry up, so they don’t want to wait too long.”
Fridson notes that the spread remains below the 161-basis-point monthly average going back to December 31, 1996. And the recent 3.14 percent yield for the Bank of America Merrill Lynch investment-grade corporate bond index is far below the average of 5.39 percent over that period.
Meanwhile, investors might be attracted to corporate bonds by the wider spreads. “We have had investors ask us about credit broadly,” Shah says. “Some are looking at high yield. But government bond investors are looking at investment-grade credits.” That includes investors across the board, particularly Japanese investors, because of the minuscule yields on Japanese government bonds, according to Shah. Experts expect the spread to stop widening within a few weeks, as the oil market stabilizes and the U.S. economy continues to chug along. “We believe the spread will narrow meaningfully by the end of the first quarter,” Shah says.
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