A Tough Road Ahead for Corporate Bonds

Dave Sekera: In the near term, we think that the corporate market has a tough road ahead of itself. The Federal Reserve continues apace to reduce its asset-purchase program and should wind up its asset purchases this fall. As such, we believe that interest rates will probably start to rise as they normalize towards more historical norms--looking at GDP growth, inflation, and inflation expectations.

To get to a more normalized level, we think the 10-year Treasury should be above 3.5%. Now historically, oftentimes, we saw that the Treasury spread between the corporate bond and the underlying Treasury bond would tighten as interest rates went up. However, we don’t really foresee that happening this time around.

So, for example, the average spread in the Morningstar Corporate Bond Index is 105 basis points over Treasuries right now. Historically, the tightest it ever got--in February of 2007--was 80 basis points. So, on the face of it, it appears as though you could have another 25 basis points of upside to get to those historically tight levels. However, the problem is that the average rating in the index right now is actually a single A-minus, and that’s lower than what the average rating was back in February of 2007 when [the Morningstar Corporate Bond Index] hit its tightest.

Now, if we look at the differential in order to do a rating adjustment between the two, there are about 15 basis points right now in the market between single A and single A-minus bonds. So, that spread adjustment really shows us that there is only probably 10 basis points of potential upside before we get to those historically tightest levels, which we don’t even really think that we should probably deserve to get back to those levels anyways.

As such, going forward we really think that the corporate bond market is going to be much more closely tied to Treasury-bond returns than it has been in the past.