There are several risks universally associated with investments in fixed-income securities. Some of these risks include default risk, liquidity risk, reinvestment risk and interest rate risk. For United States Treasury securities; however, the market considers these fixed-income securities to be free of default risk.
Investors, therefore, require that bonds issued by entities other than the federal government carry a premium yield-to-maturity so they can be compensated for the added default risk. This premium, called the credit spread, is the extra yield investors require for taking on the added default risk associated with investing in corporate bonds.
Credit spread risk, which is the risk that credit spreads will widen, is often overlooked by fixed-income investors. Today, corporate bond credit spreads are at or near their 13-year lows. (See the accompanying graphs below.)
As the Fed continues raising the Federal Funds rate to systematically slow an expanding economy and reduce the risk of future inflation, corporate bond investors may be harmed by both rising market interest rates and widening credit spreads.
Credit spreads, which are most often expressed for corporate bonds in basis points (one basis point is one-hundredth of a percent), widen during economic slowdowns because investors sell riskier corporate bonds and invest in safer Treasury bonds. This selling pressure decreases corporate bond prices and increases their yields. Investors take this “flight to quality” because they are concerned that corporations may not be able to meet their debt obligations as their cash flows decrease during periods of slower economic activity.
Today, the economy is expanding at a respectable rate with relatively low inflation. The equity and bond markets, however, indicate that future economic growth may slow. The shape of the yield curve, an excellent predictor of future economic activity, is still upward sloping, but it is much less steep than one year ago. This shape indicates an economy that will grow, but at a much slower rate.
Additionally, equity investors brought the Dow Jones Industrial Average down for the first three weeks of 2005. The Dow Jones had not begun a year with three straight down weeks since 1982. This poor performance indicates that equity investors do not have much hope for exceptional economic performance going forward.
If the market’s tale is correct, we can expect the economy’s growth to slow in the not-so-distant future. If and when this scenario occurs, credit spreads should widen. An investor can take care to protect his or her fixed-income portfolio from credit spread risk by reducing his or her portfolio’s duration and increasing its average credit quality in response to this environment of historically narrow spreads.
Note: A version of this article appeared in the February 2, 2005, edition of The Daily Record, a law and business newspaper published in Rochester, New York.