Credit Spread Compression ‘Softens’ the Impact of Rising Rates
For much of the past year, we’ve seen long-term interest rates go down and Covid-19 numbers go up. That trend reversed itself dramatically in February, with coronavirus infection rates continuing to decline from their January peak, and interest rates finally topping their pre-pandemic high. The first trend is obviously great news. The second trend might sound like a concern for bond investors, but is not necessarily, thanks to a factor called credit spread compression. I’ve explained how it works before in this newsletter, but now is a great time to explain it again since you’ll see its “softening” effect demonstrated on your next statement.
The inverse relationship between bonds and interest rates is one of the best-known principles of investing: when interest rates go up, the values of bonds and bond-like instruments go down, and vice-versa. At the start of 2021, the yield on the 10-Year US Treasury rate was at 0.93%—still below 1%, as it had been since March 20th of last year. By the end of February, it was near 1.5%.* Technically speaking, that means the value of a 10-Year Treasury bond in your portfolio should have been down by about 5% on the year. In other words, if you had $100,000 in 10-Year Treasuries on January 1st, you should have had approximately $95,000 on March 1st. At these low rates, it would probably have taken you several years to earn that money back.
However, when you look at your February statement once you receive it this month, you’ll see your values aren’t down by 5%; they’re down by much less. Everyone’s statement will be different since each strategy is customized, but some of you may see your overall portfolio down by only 1%. The reason for this is credit spread compression. Also, if you’ve been reinvesting your interest and dividends along the way, your portfolio may not have dropped in value at all.
A ‘Natural Softener’
The simplest way to explain it is to note that when we talk about bond values going down when interest rates go up, it must be the interest rate commensurate with that specific class of bonds. For example, if you have a risk-free US treasury bond, it tracks the US treasury rate. If, on the other hand, you have a triple-B corporate bond, then the rate that affects your bond is the one commensurate with triple-B corporates, which is different from the US treasury rate. It’s different still for a double-B corporate bond. These differences are important when it comes to how volatility within the bond market affects your portfolio.
When interest rates go down, it’s typically because consumers and investors are worried about the economy. This has certainly been the case for most of the past year as the coronavirus has continued to fuel economic hardship and uncertainty. On the flip side, when interest rates rise, it’s usually because people are growing more confident about the economy, as well as the prospect for more growth and inflationary pressure. With vaccine distribution ramping up, Covid-19 cases dropping, and more federal aid likely on the way, that kind of confidence is now on the rise.**
Why is all that so important to understand? Well, when you’re worried about the economy, you might be willing to buy a risk-free US treasury at a certain interest rate. However, in order to go from that investment to a triple-B corporate bond, you might demand a much higher rate to feel that it’s worth your while. Although, when you’re confident about the economy, that rate difference between the government bond and the corporate bond might not need to be nearly as great for you to make the move. That’s called the risk premium, defined as the amount of extra interest an investor would require to go from a risk-free treasury to a corporate bond of a particular grade. As interest rates rise due to investor confidence, risk premiums shrink, creating a “natural softener” for actively-managed income portfolios. This is the phenomenon known as credit spread compression.
So, even though the yield on the 10-Year Treasury rate has gone up by over six-tenths of a percent since the start of the year, the rate on certain triple-B and double-B corporate bonds may only have gone up by one-tenth of a percent. For you, that means even though long-term rates have skyrocketed overall, your specific allocation has helped prevent your portfolio values from dropping. The impact has been significantly softened, thanks to credit spread compression.
It Gets Better
This phenomenon illustrates an important point I make frequently: the notion that bond values drop whenever interest rates rise is a huge oversimplification. Many factors affect bond values, including risk premiums. What’s even better is that typically when interest rates rise as rapidly as they have been, they’ll eventually level off and perhaps even drop slightly again. When that happens, income investors will have a little tailwind that could bring any drop in values back by about halfway, at least.
The even better news, of course, is that regardless of whether your bond values go up or down on paper, you can still count on getting the full value of your principal investment returned when the bond matures, provided there is no default. Even more importantly, no matter what happens between now and then, you know that your income return is unaffected!
**“US Consumer Confidence Improves as Covid-19 Cases Fall,” Reuters, Feb. 23, 2021