Recently, we’ve been telling clients, “For the first time in several years, there’s value in swapping out of Treasuries into investment grade and high yield corporate bonds.” It’s fair to ask “what’s changed”.
When economic conditions are favorable, investors are willing to invest in lower rated bonds in order to achieve higher returns. The healthy economy of the past several years, in conjunction with low interest rates in general, pushed the appetite for higher returns (and conversely the willingness to accept riskier securities) to the point where the incremental income one could expect from BBB rated corporate bonds instead of U.S. Treasury Notes (rated AAA) was miniscule.
The recent turmoil in the credit markets has dampened investors’ enthusiasm considerably and there has been a noticeable “flight to quality” as investors sell lower rated securities and buy US Treasury Notes. While spreads aren’t back to the levels of 2002, we are finding opportunities in investment grade and high yield corporate bonds. For example, prior to the sub-prime mortgage fiasco this summer, mortgage pass through securities (bonds) issued by the Government National Mortgage Association which are fully guaranteed by the federal government had a slight yield advantage to Treasury bonds – less than 1%. With the recent flight to quality and away from anything with the word mortgage in it, these bonds now yield 1 ½% more than Treasuries, and we’ve been adding to positions in non-taxable accounts.