High Yield and Investment Grade Bond Spreads

Chart of the Week for December 2-8, 2005

Bond yields generally reflect current interest rates plus a risk premium and are historically higher for those borrowers that have a greater probability of defaulting on their debt. For instance, a borrower such as the US Treasury can attract investors even with a lower yield. Non-investment grade borrowers (those with a credit rating of BB or lower) on the other hand, must offer investors a higher yield to compensate them for the additional risk they are taking. One can draw a comparison between non-investment grade borrowers and consumers with poor credit scores. Individuals with low credit scores typically pay higher annual percentage rates on their credit cards and loans than those consumers with strong credit scores.

Over the last several years the spread or the yield difference between lower risk bonds and higher risk bonds has narrowed significantly. In Fall 2002 the yield spread was at historically high levels, and in the ensuing three years the yield spread has fallen to levels well below historical averages. This phenomenon has partially been fueled by a deepening of the capital markets, helping to make credit available to almost any company that wants it. In addition, it appears that “yield-starved” investors can now be enticed to buy with only modest additional yield return.

Yield opportunities change over time with market conditions, and the relative risk assumed by bond investors likewise changes. It is difficult to determine what factors are driving credit markets throughout market cycles and what their ultimate impact will be on investment returns, so it is important to remain diversified both in terms of equity and bond exposure.

This illustration was compiled by information from outside sources. These companies are not affiliated with ICMA-RC. This information is being provided for educational purposes and is not intended to be construed as or relied upon as investment advice. ICMA-RC does not offer specific tax or legal advice. Individuals are advised to consider any new investment strategies carefully prior to implementing.

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