Corporate bonds have had an incredible run over the past few years. A combination of sub-par growth, the sovereign crisis in Europe and massive amounts of QE on a global scale has driven government bond yields down to historically low levels. At the same time, corporate bond spreads have tightened significantly from the crazy levels we saw in 2009. This has meant double-digit annualised returns from parts of the investment grade market (as you can see from the chart Richard posted yesterday), albeit with some spread volatility in ‘risk-off’ periods.
How do corporate bonds generate similar returns from here? Well, there’s no doubt it’s going to be difficult. Given the duration of the iBoxx £ Corporate index of just under 8 years, we’d need to see yields fall roughly 1% further. So, either 10 year gilt yields would have to rally to less than 1% (from today’s 1.7% level) with spreads staying broadly flat, or spreads would need to tighten significantly with gilt yields stable (or of course any other combination of gilt yield/credit spread moves equivalent to about a 1% fall in overall yield).
Focussing purely on the credit spread and using history as a guide, there certainly is room for further tightening – for example, the spread of the BofA Merrill Lynch BBB Sterling Corporate & Collateralised index was 292bps at the end of March, 191bps wider than the pre-crisis tight of 101bps at the end of May 2007. But what could be the catalyst for such a tightening of spreads?
In the latest version of our Panoramic series we look at what drives the relationship between corporate and government bond pricing, how this has been changing over time and what might ultimately lead to corporates trading at even tighter levels than before the financial crisis.