Daily Spotlight: Bond Spreads Tighten

Summary

Treasury bond yields have been rising in recent weeks on concerns about stubbornly high inflation. Meanwhile, corporate bond yields have risen, but not as rapidly as Treasury yields, as investors remain optimistic about the potential for economic and profit growth — and thus lower default rates. As a consequence, spreads between corporate and Treasury bond yields have narrowed. The spread between AAA-rated corporate bonds and 10-year government bonds in August was 78 basis points (bps), below the 35-year average of 123 bps and down 30 bps from May. The gap between the government 10-year bond yield and a BAA-rated bond (still investment grade) in August was 185 basis points, below the historical average spread of 231 bps and down about 15 bps from the prior month. We watch these spreads closely for a couple of reasons. From an asset-allocation standpoint, tight corporate bond spreads signal that prices are above historical fair value, and we may look to underweight the segment in our model portfolios. From a broad market standpoint, the changes in the spreads offer clues to the bond market’s view of corporate financial strength, which appears to be improving given the narrowing spreads. This is important as the economy approaches a period of slower growth.