Investment Grade Corporate Bonds

A cyclical uptrend in corporate bond yields turned into a rout in
the latter part of 2008, as economic free fall spread fear rapidly
through the corporate bond market. However, by late in the year,
investors began to recover confidence that strong companies and
their bonds could weather the storm. It was not smooth sailing
though as another wave of fear gripped the market over Q1 '09
before bond prices firmed again and yields fell.

In the early stage of an economic recovery, investment grade
corporate bonds can fare better than Treasuries as investors
gain confidence in the business outlook and do sector swaps from
Treasuries into high grade corporates and subsequently into lesser
quality credits. Moreover, the willingness to assume greater
credit risk can lead to rising corporate bond prices even as Treas.
prices fall. This rotational process can go on for an extended
period, especially if short rates are so low that investors push
extra hard to pick up yield.

So, it is interesting that high grade corporate yields have
stabilized and advanced in recent months. Top grades trade at
a roughly 200 basis point premium to 10 yr Treasuries when
it would not be surprising if they traded at only 100 bp over the
10 yr. Note also that yield spread between high grades and lesser
light BBBs is also still relatively wide. This does suggest that there
remains residual investor fear about how solid and durable the
economic recovery may be. The fast answer is that as the economy
proceeds with recovery, confidence will grow and yield spreads
will narrow further in the bond market. That is not a troubling
response as it stands. However, because high grade yields have
been moving more sympathetically with Treasury yields, players
have to keep in mind that further swapping out of Treasuries
into corporates could be accomplished as both yield levels rise
and that further swapping need not produce rising prices for
corporates and falling yields. In short, narrowing yield differentials
in quality may not assure the elimination of price risk as you
purchase corporates. If you are using bonds in your investment
portfolio, keep this issue in mind since an upturn in corporate
yields could accompany the same in the Treausry market.

Moody's BAA chart here.