INVESTMENT UPDATE

Chart of the Month - Spike in Bond Spreads Explained

  • 06 November 2020
  • 5 mins reading time

The spike in bond spreads explained

Data shown: The “spread” or difference in percentage points between yields on 10-year US Treasuries (government bonds) which carry the lowest-risk rating of AAA, and the yields on investment grade bonds that have a higher-risk rating of BBB. Source: SPW/ Bloomberg, 3 November 2020

The price and yield of a bond move in opposite directions. As a result, when the demand for and price of a bond rises, its yield falls. Also, generally speaking, the higher the risk associated with an investment, the higher the potential reward that investors demand in order to compensate them for taking that risk.

When the economic outlook is positive, there tends to be greater demand for investments that carry greater risk and offer greater potential rewards. The reverse is also true, which is why the demand for and prices of 10-year Treasuries rose during the economic turbulence that accompanied the lockdowns earlier this year. That sent their yields down sharply.

At the same time, investors were worried that company profits were being reduced, making it harder for those companies to maintain payments on the bonds that they had issued (represented in the chart by the BBB-rated bonds). So the demand for and prices of those bonds fell, sending their yields up.

As the chart shows, this led to an unusual spike in the difference between the yields on 10-year Treasuries and BBB-rated bonds. We moved some money into corporate bonds when this developed because we anticipated the demand for and prices of BBB-rated bonds to recover, sending their yields back down, closer to those of Treasuries. Happily, that played out as we expected, and we have since closed the trade.

It is important to note that this is just an example of an action we took in some portfolios. It isn’t necessarily appropriate for all investors, but it does demonstrate some of what has been happening in markets this year, and how an apparently bad situation might create positive opportunities.

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