Investors will often look at the credit spread between different sectors of the bond market so they know how much extra yield they can earn for taking extra risk. For example, investment grade corporate bonds are going to yield less than high yield corporate bonds. The reason why is because there is a higher rate of default among high yield issues. By looking at the spread between investment grade and high yield corporate bonds, you can see how much extra return is being offered for taking on additional risk. (Don’t know the basics of credit srpeads? go here. )
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Yield spreads between different sectors of the bond market also change over time. To see this in action take a look at the chart below, which shows the credit spread for investment grade corporate bonds (red line) and the credit spread for high yield corporate bonds (blue line). As you can see from the chart the spreads for both sectors of the market tend to rise and fall together.
However, as you can also see from the above chart, the magnitude of the moves are not the same. When credit spreads rise or fall, the credit spread on high yield corporate bonds tends to rise and fall a lot more than the credit spread on investment grade corporate bonds. The chart below which shows the difference between the two lines in the above chart:
This also shows how much extra yield new buyers receive for taking the extra risk involved with high yield bonds at different points in time. During periods of a growing economy and relative calm in the markets, the extra yield earned for taking on the extra risk of Junk bonds is very small at around 1%. When the market becomes concerned about the economy due to slowing growth or other factors, the amount you get paid for the extra risk involved in junk bonds spikes.
What can we learn from this as bond investors?
By looking at how tight or wide the spread is between different sectors of the market we can get a feel for how “cheap” or “expensive” different sectors of the market may be. If the spread is very wide it may make sense to invest in riskier bonds where you will not only earn a higher yield but also benefit when spreads eventually come back to more “normal” levels. If spreads are very tight, it may make sense to stick to less risky bonds since the additional compensation offered at the current time may not be worth the extra risk. (Want more info on how to buy and sell junk bonds? Go here.)
This also allows bond investors who have a strong view on where the economy is headed to express that view in the market. For example, if the economy is currently performing poorly and there is a lot of concern in the market, then the spread between high yield and investment grade bonds is likely to be wide. If an investor felt that things were about to start improving, they could invest in high yield bonds. As the economy starts to improve and investor concerns ease, the spread between high yield and investment grade bonds should narrow and the price of high yield bonds should rise.
What will ultimately determine which strategy is the most profitable, is the actual default rate vs the extra yield earned for taking additional default risk. There is no way to know for certain what this will be in the future, however we can look historical yields and defaults rates in order gain some insight. This will be the topic of the next article.
This is of course only one of the variables that investors will consider but is often a good place to start. For other things you may want to look at see our article “Do it yourself credit analysis“.Get our free guide to income investing here.