Can Tight Spreads Still Deliver Excess Returns?

Over the past 18 months, investment grade (IG) corporate credit spreads have narrowed considerably in response to solid fundamentals and a strong economy. Given the tight spread levels, should investors reconsider the attractiveness of owning corporate bonds and instead buy Treasury securities? Even though corporate debt appears fully valued, the ICE BofA 1–10 Year US Corporate Index offers a 5.5% effective yield, so we think opportunity still exists.

To see why, let’s discuss the factors that determine credit spreads and the return potential of corporate bonds relative to Treasury notes. Then we can review why spreads are so narrow now and examine an extreme example of widening credit spreads that supports the case for investing in corporate bonds.

How are spreads and relative performance measured?

While Treasurys are considered risk-free investments, corporate bonds carry default and downgrade risk. As compensation for this risk, investors in a corporate bond receive a yield greater than the yield on a similar maturity Treasury. This extra yield is known as the credit spread.

Spreads fluctuate according to the market’s perception of these risks—typically widening during recessions, when downgrade and default risks increase, and narrowing during good economic times, when earnings improve and downgrades become less likely. Importantly, the yield spread above Treasurys not only compensates investors for additional risk but can also act as a shock absorber to dampen volatility if interest rates rise. Wider credit spreads offer greater protection, and narrower spreads less protection.