The Long and Short

If adding credit risk or duration to get yield, pick credit

Dan Bruzzo, CFA | October 27, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Investors in the secondary corporate bond market routinely face a choice of adding either credit risk or duration to supplement yield. The dynamics of the corporate market have changed considerably over the past 12 months, with interest rates surging higher in recent weeks and spreads gapping wider. For now, the best way to supplement yield is by rotating from ‘AA’ credit to ‘A’ credit.

Investment grade spreads recovered sharply from the wides of March, when index OAS touched 163 bp during the regional bank-related sell-off. But that spread hit a local tight on July 31, with an OAS of 112 bp. After trading sideways throughout most of August and September, spreads have leaked wider with the most recent move to higher US Treasury rates. Higher rates and wider spreads have pushed up and flattened out the opportunity set of the investment grade corporate yield curve (Exhibit 1). Comparing trading strategies spread and yield compensation against their historical ranges, rotating from ‘AA’ credit to ‘A’ credit looks the most compelling.

Exhibit 1. US Treasury and investment grade yield curves: current versus 1Y ago

Source: Santander US Capital Markets, Bloomberg

Trading from ‘A’ credit to ‘BBB’ credit is currently about a full standard deviation below the mean. Investors currently earn an additional 42 bp of approximate spread to move down in credit to ‘BBB’ from ‘A’ (Exhibit 2). On an historic basis, the 10-year average spread pick is 58 bp with a standard deviation of 17 bp. This trend as not surprising as investors have been favoring industrial credit versus financials—particularly ‘A’ rated banks—amidst the selloff in rates. As a result, investors are demonstrating more comfort holding ‘BBB’ rated credits that fall outside the bank and finance sectors, which has eliminated much of the typical spread curve to move down in credit.

Exhibit 2. ‘A’ OAS compared to ‘BBB’ OAS

Source: Santander US Capital Markets, Bloomberg corporate index OAS

Alternatively, once again moving from ‘AA’ to ‘A’ looks like the best value for investors in the secondary corporate bond index. Bondholders can currently earn an additional 52 bp of spread to move down in credit to ‘A’ from ‘AA’ (Exhibit 3). That level compares with an average spread pick of 29 bp, which is getting close to two full standard deviations (9 bp) above the 10-year average. As you can see on the graphic, spreads hit a similar dynamic at the same time last year, peaking slightly higher, before sharply correcting over the next several months. These are some of the highest levels for risk compensation for the ‘AA’ to ‘A’ trade since the peaks of the global pandemic. This appears the most attractive option for investors to achieve incremental yield relative to historical relationships in the studies presented here.

Exhibit 3. ‘AA’ OAS compared to ‘A’ OAS

Source: Santander US Capital Markets, Bloomberg corporate index OAS

(See article: Adding value by moving from ‘AA’ to ’A’ credits)

Investors can also extend credit portfolio duration along different parts of the yield curve:

3-year to 5-year
5-year to 7-year
7-year to 10-year
10-year to 30-year

The extremely flat yield curve for investment grade corporates is highly evident in the historical data and the current yield ladder presented in the next four graphics. The first of these options currently presents the opportunity to add just under 17 bp of yield for a move from 3- to 5-year maturity. That compares with a 10-year average of 43 bp but is the only duration relationship in the study to be trending above a full standard deviation below the mean and would therefore technically represent to be extension trade option among the four. Meanwhile, an extension trade from 5-year maturity to 7-year maturity offers up just under 13 bp of incremental yield. That compares with a 10-year average of 39 bp and right around a full standard deviation below the mean. An extension trade to 10-year maturities from 7-year is in an even worse historical position with a yield differential of less than 9 bp versus a 10-year average of 41 bp and a standard deviation of 18 bp. Not surprisingly, the worst among the four options is the extension trade to 30-yr duration from 10-yr duration given the inversion of the long-end of the curve. Investors give up 4 bp to move out the curve, versus the 10-year average of receiving 58 bp, which is about two full standard deviations below the mean. So, once again, among the options presented here, the 3-to-5-year trade offers up the better yield grab historically versus the other three; but as demonstrated earlier, investors are better suited to seek yield through down-in-credit strategies versus taking on additional duration risk.

Exhibit 4. Incremental yield for moving to 5-year corporate from 3-year

Source: Santander US Capital Markets, Bloomberg corporate yield curves

Exhibit 5. Incremental yield for moving to a 7-year corporate from a 5-year

Source: Santander US Capital Markets, Bloomberg corporate yield curves

Exhibit 6. Incremental yield for moving to a 10-year corporate from a 7-year

Source: Santander US Capital Markets, Bloomberg corporate yield curves

Exhibit 7. Incremental yield for moving to a 30-year corporate from a 10-year

Source: Santander US Capital Markets, Bloomberg corporate yield curves

Dan Bruzzo, CFA
dan.bruzzo@santander.us
1 (646) 776-7749

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