Last week we argued that corporate bonds look reasonably priced and appear cheap relative to Treasuries. Now, I want to address the logical follow-up question: How do you know what a fair price is for corporate bonds?
One way to think about corporate bond valuations is to consider the spread. Investors in corporate bonds are assuming credit risk – the risk that the issuer won’t repay the principal or make good on an interest payment. Investors are arguably not subject to that risk with a Treasury bond (for all its troubles, the U.S. government has never defaulted).
As investors are taking on marginally more risk, they should be compensated in the form of a higher return. The spread between the interest on a corporate bond and a Treasury obligation of a similar duration is one way to assess how much investors are being compensated for taking on additional risk.
In general, when the economy is stronger, spreads tend to contract as investors are less worried about companies defaulting. Conversely, when the economy is weaker investors should receive a higher return to compensate for the risk of increased defaults (as you would expect, defaults rise in recessions).
So when it comes to evaluating how wide the spread should be, start with your view on the economy. By comparing your view of the economy to current spreads, you can get at some rough measure of “fair value.”
Today, spreads are wide relative to their historic average – but they also appear wide given the state of the economy.
The spread between an index of Baa corporate bonds and the 10-year U.S. Treasury note is approximately 3.30%, nearly twice the historical average. In other words, investors are sufficiently worried about the state of the economy that they are demanding twice the premium relative to Treasuries they normally receive (another interpretation is that Treasury yields are artificially low because the Fed is buying up a good chunk of existing supply).
But when we compare the current level of spreads to a measure of leading economic indicators (see the chart below), spreads also look too big. Based on this analysis, spreads should be about 1% tighter than they currently are, meaning that either Treasury yields should rise or corporate bond yields should fall.
Either way, corporate bonds look better than Treasury bonds.
Click to enlarge
Please note: Bonds will decrease in value as interest rates rise.