While inflation remains low and the Fed remains unlikely to increase rates dramatically in the next year, defaults pose the biggest threat, says Morningstar's Tim Strauts.
Note to readers: Bob Johnson is on sabbatical, and his column will return on Nov. 15. In place of his weekly update, Morningstar.com will be posting video reports featuring members of Bob's team as well as Francisco Torralba from Morningstar Investment Management, highlighting recent economic data and trends.
Tim Strauts: In today's chart, we are going to look at corporate-bond credit spreads and discuss how they impact your portfolio. The chart shows the historical credit spread for AAA, BBB, and high-yield securities since 2010. For those not familiar with this metric, a credit spread is the difference in yield between two bonds with similar maturities. For example, the high-yield credit spread on the chart is the yield of high-yield bonds subtracted by the yield of U.S. Treasury bonds of similar maturities. The measure tells you how much you're paid as an investor to take the risk of investing in a security that could default. In general, rising credit spreads are an indication that the market thinks the chance of default is increasing.
There are two primary risks that fixed-income investors accept when investing. They are interest-rate risk and credit risk. In the last several years, it seems that everyone is concerned how rising interest rates will affect their portfolios. One of the primary ways investors have reduced interest-rate risk is by owning shorter-maturity securities. Unfortunately, bonds with lower maturity pay less interest. So, to compensate, people have been buying bonds with higher credit risk.
With inflation at very low levels and the Federal Reserve unlikely to raise interest rates dramatically in the next year, the biggest risk to a fixed-income portfolio right now is increased defaults. In the last quarter, high-yield credit spreads rose dramatically, which caused principal losses in most high-yield funds. The U.S. economy, as a whole, is still doing well, but current credit spreads are above their long-term average level, which is in indication that there is increased risk in the current market. In conclusion, now may be a good time to re-evaluate your portfolio and make sure you're balancing credit and interest-rate risk and not tilting your portfolio toward too much of either one.
