BB-Rated Bond Yields Closing in on BBBs

Portfolio Manager John Lloyd explains why the current relationship between investment-grade BBB spreads and high-yield BB spreads may present opportunities across bond market sectors.

Key Takeaways

  • BB-rated corporate bond spreads have tightened relative to BBB spreads for over a decade; when the difference is adjusted for their durations, BB bonds are on the cusp of trading more expensively than BBB bonds.
  • If U.S. Treasury rates continue to decline, we could see BB spreads trade tighter than BBB spreads, but the prospect of buying BBB-rated bonds at or near the spreads of BB-rated bonds is compelling on a risk-adjusted basis.
  • The current relationship between investment-grade BBB spreads and high-yield BB spreads indicates that opportunities may be found not only within sectors, but also across sectors.

The spread over U.S. Treasuries for the BB-rated segment of the U.S. high-yield market has tightened steadily, albeit slowly, relative to the spreads of BBB-rated bonds since the Global Financial Crisis. But the trend has accelerated and, in the past year, the extra spread earned by holding BB bonds has set new 20-year lows. Even more striking is the difference between the two rating segments’ spreads after adjusting for their durations (the BBB segment historically has had a duration one to two years longer than the BB segment).

Difference Between BB and BBB Spreads, Duration-Adjusted

Source: Bloomberg Barclays, as of 10/31/19.

On a duration-adjusted basis, the extra yield paid for holding BB bonds over BBB bonds has fallen sharply and is currently on the cusp of being negative. Should the trend continue, BB-rated bonds could pay less – when adjusted for their shorter duration – than higher-rated BBB bonds.

The duration of BBB bonds has been trending higher (setting a 20-year high as recently as September) for the last two decades. If interest rates continue to decline, their duration may continue to rise given that lower yields incentivize companies to borrow for longer terms.

While there is a similar incentive for BB-rated companies, the callability – i.e., the ability of issuers to redeem the bonds early – of many BB bonds causes their duration to shorten as market yields fall below their coupon rates (about 70% of the high-yield market is callable). In the past year, the duration of BBs has fallen just over 20%, from 4.3 years one year ago to 3.4 years as of October 31, 2019.

Should U.S. Treasury rates continue to decline, we could see BB spreads trade tighter than BBB spreads, particularly on a duration-adjusted basis. But the prospect of buying BBB-rated bonds at or near the spreads of BB-rated bonds is compelling on a risk-adjusted basis.

As we wrote in our recent blog post, Bond Market Dynamics Highlight Importance of Diversification, the recent convergence of sector-level spreads can mask significant volatility within sectors, but that does not mean there are not still opportunities for active investors. The current relationship between investment-grade BBB spreads and high-yield BB spreads is another example of how there can be opportunities not only within sectors, but also across sectors.