Rising interest rates are to blame. With the Federal Reserve Bank continuing to hike the short-term fed funds rate, longer-duration investment-grade bonds with historically low yields have suffered.
“The hit from interest rates has been a big deal,” said Elaine Stokes, a fixed-income strategist and manager of several bond funds at Loomis Sayles. While the spread between investment-grade bonds and the 10-year Treasury has widened from 90 basis points in early February to as much as 130 in July, she doesn’t think that represents a buying opportunity.
“The spread is still not very attractive,” said Stokes. It currently stands at 113 basis points. “The yield and credit spread curves are too flat,” she added. “You’re not getting paid enough to go down in quality or longer in term.”
Investment grade is also not what it used to be. There is widespread concern that the sheer volume of debt issued by investment-grade companies since the financial crisis could be a problem when the economic cycle turns. Corporate investment-grade bonds now total roughly $6 trillion, versus just $2 trillion before the financial crisis. Some of that is a result of economic growth, but corporate leverage by all measures is much higher than it was in the last cycle.
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The ratings distribution of the market is also far more skewed to the lower end of the scale. There are only two corporate issuers in the United States — Microsoft and Johnson & Johnson — rated AAA, and bonds rated BBB, the lowest rating of the investment-grade market, account for 50 percent of the Bloomberg Barclays investment-grade bond index, versus 38 percent prior to the financial crisis.
“Leverage is way up,” said Erin Lyons, U.S. credit strategist for CreditSights. “The concern is over how much riskier BBB bonds are now.”
“Some think many of them shouldn’t have investment-grade ratings.”
As borrowing costs rise with interest rates and the economy slows, there could be a wave of so-called fallen angels from the lower end of the investment-grade spectrum. That in turn would cause an exodus of institutional investors who don’t invest in junk bonds.
On the positive side, the carrying cost of debt is far lower than in previous cycles. With the Fed’s ultralow interest-rate policy since the financial crisis, investment-grade coupons in many cases are less than half what they were before the crisis. Companies have understandably loaded up on cheap money. With the strong U.S. economy, the ability of companies to shoulder higher leverage has increased.