Investment-Grade Credit Spreads Widening

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Investment-Grade Credit Spreads Widening

By Alan Gula, Chief Income Analyst

What do McDonald’s (MCD), Philip Morris (PM), Caterpillar (CAT), Kimberly-Clark (KMB), and Target (TGT) have in common?

Yes, they’re all large-cap stocks that pay solid dividends.

In fact, three are even Dividend Aristocrats, having increased their dividends for at least 25 consecutive years.

But the common characteristic I’m referring to isn’t related to their dividends . . .  or even their common stocks. Instead, I’m looking higher up in the capital structure.

Specifically, each of the above companies is rated single-A by Standard & Poor’s, a major credit ratings agency.

They may not be AA- or AAA-rated, but single-As still have excellent credit worthiness, and tend to have narrow credit spreads (the additional yield provided by a corporate bond above that of U.S. Treasuries to compensate investors for the risk of default).

At the moment, though, credit spreads for investment-grade (IG) corporate bonds are actually widening.

For their part, many market watchers are quick to dismiss the selloff in high-yield bonds, attributing it solely to the turmoil in the energy sector. But this is a mistake in its own right.

Meanwhile, the companies I’ve mentioned are a far cry from super-speculative, highly leveraged oil exploration and production firms.

Indeed, high-quality bonds have started selling off, too, and most are outside of the energy sector.

After spending the majority of 2014 below 1% (100 basis points), benchmark single-A credit spreads have now pierced this key level, as you can see below:

Heading into 2015, there are two important takeaways from the action in IG credit spreads:

1. Spreads on single-A rated bonds still aren’t very wide. They’re rising from a very low level, historically speaking. So, in general, IG corporate bond investors aren’t being generously compensated for their credit risk exposure. As a whole, IG corporates aren’t very attractive investments… yet.

1. Single-A credit spreads stayed below 1% from early 2003 all the way until July 2007. When the S&P 500 peaked in October 2007, benchmark spreads had risen to around 1.3%. The bond market was flashing a huge warning signal, and this divergence is starting to reappear. If single-A credit spreads continue to widen, I’d categorize this development as a significant warning sign that a major market top in equities is forming.

As I’ve said before, the bond market leads the stock market. Don’t dismiss the selloff in high-yield bonds, and keep a close eye on widening investment-grade credit spreads.

Safe (and high-yield) investing,

Alan Gula, CFA

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By Alan Gula