A quick look at a timely topic of interest - with a brief review of why it could matter to investors.

Chart of the Week

October 5, 2015

Corporate bonds: Priced-in pessimism?
2-year swap spread and high yield option adjusted spread (OAS)


Source: Bloomberg, as of 10/7/15. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The bottom line:

  • Between turmoil in the energy sector and a significant slowdown in global growth, US investors have good reasons to ask "is the economy headed for trouble?"
  • The answer is far from clear: in fact, two leading indicators of economic health – swap spreads and high yield spreads – tell opposite stories.
  • Widening credit spreads, especially in the high yield sector, clearly reflect fears about a worsening economy and an increased risk of default among riskier corporate debt.
  • Yet the 2-year swap spread is sending the opposite message.
  • Swap spreads have come down in recent months—reflecting greater confidence that counterparties (i.e. those who use swap agreements to hedge against or speculate on future changes in interest rates) will make their payments.
  • Low swap spreads tend to be associated with healthy overall growth and liquidity.

Indeed, recent tightening may even suggest the economy could improve in the months ahead.

  • The current divergence between these two statistics is unusual. As evident in the chart, they've typically moved in the same direction in recent history—the present disconnect stands out as unusual.
  • Another notable disconnect occurred during 2002 as the aftermath of the 9/11 attacks and a spate of corporate accounting scandals sent high yield spreads soaring, but not swap spreads. Interestingly, the high yield index returned 29% in 2003 and 11% in 2004¹, although past performance is no guarantee of future results.
  • If the swap spread is the correct signal, it could mean excess pessimism is priced into the credit markets. That, in turn, would suggest attractive values exist in the sector—and perhaps in risk assets in general.

The chart:

  • The chart shows the option-adjusted spread of the Barclays US Corporate High Yield Index and the 2-year US$ interest rate swap spread over the past 20 years.
  • The OAS of the Barclays US Corporate High Yield Index has widened from around 340 basis points in May 2015 to 603 basis points as of October 7, 2015.
  • Meanwhile, in the last five months the 2-year swap spread has tightened from 26 basis points to less than 13 basis points.
  • With the exception of a brief period in 2001, most of 2002 and the past few months of this year, the two spreads have generally moved in the same direction.


¹ Source: Bloomberg.


An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options. A credit spread is the difference in yield between two different types of fixed income securities with similar maturities.

An interest-rate swap is an agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps are used to hedge against or speculate on changes in interest rates.

A swap spread is the difference between the fixed interest rate and the yield of the Treasury security of the same maturity as the term of the swap. US$ swap spreads are derived intraday using swap rates and government yields.

High yield, or below-investment grade bonds are those with a credit quality rating of BB or below.

The Barclays U.S. Corporate High Yield Index covers the universe of fixed rate, non-investment grade debt, including corporate and non-corporate sectors.

Credit markets refers to sectors of the bond market, such as taxable bonds that are not Treasury securities, and includes securities such as agency securities, asset-backed securities, corporate bonds, high-yield bonds and mortgage-backed securities.

A basis point (bps) is one one-hundredth of one percent (1/100% or 0.01%).


The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.

Derivatives, such as options and futures, can be illiquid, may disproportionately increase losses and have a potentially large impact on performance.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

Yields represent past performance and there is no guarantee they will continue to be paid.


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