Corporate Bond Yields Spread Falling… Another Bullish Indicator
Posted by Lance Jepsen on July 23, 2017 4:53 PM
Tags: Bond (finance), Bond credit rating, bond yields, Corporate bond, Credit risk, Economy, Fed Funds Futures, Federal Reserve, Inflation, Moody's Investors Service, Yield spread
Categories: US Economy
Corporate bond yields spreads are falling which suggests there is a low default risk. Using Fred and Moody’s we can chart the spread between lowest investment grade (Baa) and equivalent 10-year Treasury yields.
Corporate Bond Yields Spread Chart
Corporate bond spreads are at there lowest point since 2008. This suggests that markets are pricing in a very low risk of default which is bullish for the economy.
BAA Corporate Bond Yield
Corporate Yield of a Moody’s Graded Bond. For instance, a Seasoned AAA Corporate Bond of 30 Year is the yield return of bonds graded AAA by Moody’s with a maturity of 30 years. Bonds less than specified timetables are dropped along with bonds with redemption and rating risks.
Moody’s BAA corporate bond yields are instruments based on bonds with maturities of 20 years and above. For instance, a seasoned BAA corporate bond of 30 Year is the yield return of bonds graded BAA by Moody’s with a maturity of 30 years. Bonds less than the specified timetables are dropped along with bonds with redemption and rating risks.
The credit ratings of AAA and BAA are the two ends of the ratings spectrum for investment-grade corporate bonds as provided by the Moody’s rating agency. The yield difference between bonds with these ratings has historically indicated whether the economy was in a period of recession or expansion.
The credit-rating agencies Moody’s and Standard & Poor’s provide credit ratings on bond issuers and their bonds to give investors an idea of the investment reliability of the bonds, concerning the payment of interest and principal. AAA is the highest bond rating and indicates the safest bonds for investors. Bonds rated below BAA — BBB from Standard & Poor’s — are considered to be non-investment grade. That makes the BAA rating the lowest investment grade rating. The lower the credit rating, the higher the yield a bond will pay.
The corporate bond yields spread chart above shows riskier BAA rated bonds (lowest investment grade rating), versus 10-year Treasury yields. In periods of higher default risk, the plot rises. The plot falls in periods of lower default risk.
U.S. Treasury yields are falling because of low inflation. With inflation so low, the Federal Reserve will likely not raise interest rates again until 2018. Remember, the main reason the Fed raises interest rates is to combat inflation in an over-heated economy. Clearly we do not have that.
Tax cuts and a $1 trillion infrastructure spending program would push inflation higher.
With Congress failing to repeal and replace ObamaCare, it is pushing the Trump Administration’s tax cuts and infrastructure jobs program out further. Inflation is staying low for longer as a result.
The Federal Reserve now is in a position where they do not need to raise rates to combat inflation. As a result, the Fed funds futures rate has dropped and is now showing about a 40 percent chance of a rate hike in December 2017.
Next week when the Fed meets, we could get clarification on when they will begin unwinding their $4.5 trillion balance sheet.
If you have an opinion on what the drop in corporate bond spreads means, please add your comment below.
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