The Federal Reserve (Fed) increased its bond exchange-traded funds (ETF) purchases in the week ending May 20 (the most recent data available), adding another $1.5 billion in bond ETFs to its balance sheet, bringing the total holding to $1.8 billion. With Fed purchases accelerating, the average investment-grade corporate bond spread dipped below 2% last week for the first time since March 11. (Credit spreads reflect market participants’ perception of credit risk.) As shown in the LPL Chart of the Day, spreads had been largely flat for about a month following the initial declines off 2020 peaks despite stock market gains, but Fed buying may have been a catalyst for further compression.
“Buying ETFs is a new step for the Fed and is a convenient way for it to intervene in corporate bond markets,” said LPL Research Senior Market Strategist Ryan Detrick. “Once market participants believe the Fed is willing and able to add liquidity and relieve funding pressure through ETF purchases, the Fed will probably be able to get to the same place with fewer purchases. We expect purchases to decline unless market volatility picks up again.”
Spreads have already narrowed significantly since hitting 2020 peaks. The average high-yield spread is 66% of the way back to its 15-year median of 4.66%, while the investment-grade spread is 79% of the way back to its median of 1.36%. While valuations still lean attractive, spread compression may not be a major driver of returns looking forward, for investment-grade corporates. At the same time, investors’ greater caution with high-yield bonds makes sense, since they are more vulnerable if the economy doesn’t rebound as quickly as expected.
Investment-grade corporate returns may be back to “coupon clipping” environment where returns are driven by the income they generate rather than potential for price gains, especially if increases in Treasury yields offset further declines in credit spreads. Nevertheless, the relatively attractive average coupon of just below 4% still makes them a reasonable part of a diversified bond portfolio for suitable investors. The potential for high-yield spread compression still presents some upside for this riskier bond sector, but we remain concerned about vulnerability if markets become volatile again or if the pace of the economic recovery does not meet expectations, while also seeing more upside over the long term in stocks.
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The credit spread is the yield the corporate bonds less the yield on comparable maturity Treasury debt. This is a market-based estimate of the amount of fear in the bond market. Base-rated bonds are the lowest quality bonds that are considered investment-grade, rather than high-yield. They best reflect the stresses across the quality spectrum.
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