Wednesday, January 21, 2009

Investment Grade Bonds: Attractively Priced, But With Reason

While the Barclays Capital Investment Grade Index has rallied significantly over the past few months (from slightly more than 9% to just over 7%), the yield is still significantly higher than it was pre-financial crisis, presenting what appears to be a great investment opportunity.



While a portion of this is due to the sell-off across investment grade corporate bonds, another explanation lies in the composition of the index. Since January 2007, the composition of the index has stayed relatively static with regards to holdings of Aaa and Baa rated securities. However, there has been a 7% shift by market value from Aa rated to A rated securities due to downgrades (in addition there have been downgrades from A to Baa, and Baa to high yield, which brings up survivorship bias, but that is another post altogether).



The relevance? Since early 2007, the yield of Aaa and Aa securities has stayed flat (though spreads to Treasuries have widened significantly). On the other hand, A and Baa Investment Grade corporates are 140 and 240 bps wider respectively in that period (note the crossing pattern of Baa and A yields in September / October and Aa and Aaa yields currently due to the market's disagreement with the agencies ratings, specifically financials).



In other words, a lot of the increase in 'absolute yield' levels of Investment Grade Corporate Bond indices are due to a worsening of credit, not necessarily pure market opportunity. While I personally find value at these levels, it is important to understand what risks you are taking as an investor.