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Why Corporate Bonds Could Perform Well

Corporate Bonds: Figuring Out A Fair Price (Part 5 of 5)

(Continued from Part 4)

Today, spreads are wide relative to their historic average – but they also appear wide given the state of the economy.

The spread between an index of Baa corporate bonds and the 10-year US Treasury note is approximately 1.7%. When we compare the current level of spreads to a measure of leading economic indicators, spreads also look too big. This means, corporate bonds look better than Treasury bonds.

Market Realist – Investment-grade corporate bond yields are less volatile than high yield bonds

The graph above shows the spread between AA rated corporate bonds and ten-year Treasuries, along with the 15-year average of the spread. The spread has been inching closer to its average, which is 0.4%. These are higher-quality bonds, which tend to be much less volatile than high yield bonds.

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The reason for this difference is that big companies like Apple (AAPL) and Chevron (CVX) have robust balance sheets to navigate through tough times, and their chance of default is very low compared to high yield bonds. This is why they command a premium and yield less than high yield bonds.

A tailwind for both Treasuries as well as investment-grade corporate bonds (LQD) is the hike in interest rates that could take place later this year. However, dipping inflation rates could postpone the hike.

Market Realist – High yield corporate bonds could perform well if the economy continues to improve

The graph above shows the spread between high yield bonds rated CCC or below and the ten-year Treasury (IEF) and its 15-year average, which stands at 11.4%. Although the spread is below the average line, you could still make a case for high yield bonds.

As we mentioned earlier, these bonds were battered due to the dip in oil prices. However, many analysts feel that oil prices are bottoming out, which is good news for high yield bonds, as a good chunk of high yield issuers belong to the energy sector.

Also, the US economy seems to be doing well, with the recent jobs report delivering the goods. Not only did the number of jobs created increase, but the wage rates and the labor force participation rate, which had been low for a long time, also showed signs of improvement.

Also, the GDP growth rate for 4Q14 came in at 2.6%, which is good, considering that the previous two quarters recorded GDP growth rates of 5% and 4.6%, respectively.

An improving economy is great news for corporate bonds, especially high yield bonds (HYG), as we discussed earlier.

Read our series High Yield: Be Sure To Understand The Risk for more on corporate bonds.

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