Why Tight Credit Spreads Raise Risk for Bond Investors

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Bond yields still look attractive, but investors are earning little extra for taking on corporate credit risk, according to Thornburg Investment Management.Key Takeaways: Investment-grade spreads reached their tightest point since 1998, while high-yield spreads matched pre-2007 levels. Even modest economic or policy shocks could widen tight spreads and push bond prices lower. Thornburg’s two active bond ETFs differ from their benchmarks in sector mix and sensitivity to interest rates. Credit spreads measure the extra yield that companies pay to borrow compared with U.S. Treasurys. Those spreads narrowed to historically tight levels earlier this year, client portfolio manager Phillip Gronniger wrote in a Thornburg report. Investment-grade spreads fell to roughly 71 basis points, or 0.71 percentage points, their tightest since 1998, the report said. High-yield spreads on riskier “junk” debt hit about 250 basis points, a level last seen before the 2007 credit cycle peak. That starting point has historically spelled trouble. Since 2000, investment-grade bonds with spreads under 80 basis points trailed comparable Treasurys over the following 12 months. The median shortfall was 1.69%, according to Thornburg’s review of Bloomberg data. See more: Bond ETFs & Rising Rates: Why Duration Matters Now High-yield bonds with spreads below 275 basis points fared worse, lagging Treasurys by a median 11.6%, the analysis found. By contrast, those starting above 500 basis points beat Treasurys by a median 10.06%. Gronniger described the risk as lopsided, since spreads have little room to tighten further. Even modest economic softening or policy uncertainty could widen them and push bond prices lower, he added. “When spreads are tight and the margin for error is thin, selectivity, quality, and risk control take precedence over maximizing yield,” Gronniger wrote.How Thornburg's Active Bond ETFs Handle Credit RiskThat mindset carries into Thornburg’s two actively managed bond ETFs, where managers pick holdings instead of tracking an index. The Thornburg Core Plus Bond ETF (TPLS ) invests mostly in investment-grade bonds but can put up to 25% in lower-rated debt. Thornburg says its approach is to take on risk “when we believe we will be compensated for doing so.” Securitized debt, or bonds backed by pools of loans, also plays a bigger role in TPLS than in its benchmark. As of August 31, the fund held 18% in collateralized mortgage obligations and 11.6% in asset-backed securities, according to Thornburg. The Thornburg Multi Sector Bond ETF (TMB ) invests more broadly, with “a meaningful focus on high-yield opportunities,” according to Thornburg. Even so, TMB carries less interest rate risk than its benchmark. Effective duration gauges how much a bond fund’s price moves when rates change. TMB’s stood at 4.2 years as of August 31, versus 5.6 years for the Bloomberg U.S. Universal Index, per Thornburg. TPLS charges an expense ratio, or annual fee, of 0.45%, while TMB charges 0.55%, according to Thornburg. Despite its high-yield focus, TMB’s largest holding is a U.S. Treasury note, according to its holdings list. The note made up 10.02% of the portfolio as of October 5, more than four times the next-largest position. For more news, information, and analysis, visit our Portfolio Strategies Content Hub.

Why Tight Credit Spreads Raise Risk for Bond Investors

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