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By Dave Sekera, CFA | 06-03-2014 03:00 PM

Bonds at Precrisis Levels

Corporate credit spreads are at very tight levels but have little room to further narrow the gap.

David Sekera: While we're not yet half way through the year, the Corporate Bond Index has risen about 5% through the end of May. Of that 5%, about 250 basis points or a little over half of that return has been generated by interest rates. For example, the yield on the 10-year and the 30-year Treasury bond have declined about 50 basis points since the beginning of the year.

Now the 150 basis points of that 5% return have been driven by the yield carry that you generate on fixed income. For example, the average yield in our index was about 3.2% at the beginning of the year, and we've captured 5/12 of that through the end of May.

Then finally, the remaining 1% of that return has been generated by excess returns in the corporate bond market. For example, the average spread in the Morningstar Corporate Bond Index has tightened year to date about 14 basis points; we're at about 106 basis points over Treasuries right now.

At current spread levels, the corporate bond market is trading at the tightest levels that it's traded at since before the 2008 and 2009 credit crisis. While we don't foresee any near-term catalysts on the horizon that might cause credit spreads to widen out, at this point, we really don't see anything that's going to cause them to trade much tighter in the near term, as well. In fact, if you look at the spread trading over the past eight to 10 weeks, we've really been in about 4-basis-point band of trading levels.

The other thing that I look at is the standard deviation of the credit spreads within our index. And right now, we're about one standard deviation tighter than the average historical spread going back to 1999.  I even adjusted that to take out the 2008-09 credit crisis impact, and we're still at very tight spreads on an average standard deviation basis.

Also when I think about credit spreads, the tightest our index ever got was 80 basis points back in February 2007. At that point in time, I think credit spreads were pushed artificially tight. We had a lot of things going on in the structured market, SIVs, CDOs, CLOs, other vehicles that were used to slice and dice credit and push credit spreads artificially tighter than what we thought was warranted by the fundamentals back then. So therefore, we really don't see credit spreads tightening much more from here.

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