This post was written with contributions from Wilson Huang. Wilson is a Principal in the ETF Research Team.
From monetary policy to investors’ risk appetite to issuer fundamentals, numerous factors influence credit spreads. But when it comes to investment grade credit, there may be another factor affecting credit spreads—the credit quality of bonds held in the benchmark index itself.
The composition of the Barclays U.S. Credit Index has changed drastically since its inception 30 years ago, and over time the credit quality of the index has migrated downward. The result is that credit spreads may be tighter than investors realize, and certain historical comparisons may be misleading.
Declining quality in the investment grade credit index
The historical average of an index’s option adjusted spread (OAS) is often used as a proxy for an index’s “neutral” spread level. This neutral level is then used to determine how wide or tight current spreads are compared with history. Currently, the Barclays U.S. Credit Index’s historical average, and therefore “neutral”, spread level is 122 basis points (bps).
While investors can typically take this neutral level at face value, today there is a danger in straightforward comparisons of current credit spreads to historical averages. The chart below, which tracks historical weightings in the Barclays U.S. Credit Index by credit rating, helps to illustrate why. It shows that the average rating of the overall benchmark index has declined throughout the past 30 years. Its average rating used to range between an A and an AA, to somewhere now between a BBB and an A. This is mostly due to BBB-rated bonds having grown from a roughly 25% weighting in the index in 1988 to a weighting of approximately 45% today.
The result is that the index’s neutral spread level is artificially low and is being constrained by time periods when the credit quality of the index was much higher, as the higher rated AAA bonds have lower spreads than lower rated BBB bonds. Not only is this spread level being influenced by changes in the spreads of the underlying components (e.g. spreads getting tighter due to investors search for yield above Treasuries), but it is also being impacted by changes in the weights of its underlying components—like the drift toward more BBB-rated holdings.
Shifting investment grade weights in the index
To put the impact of these index weighting changes in perspective, we examined where the index’s OAS spread level would stand if each credit rating remained fixed. To do this, we kept the spread levels of each rating bucket within the investment grade credit index static over time. For instance, we fixed BBB spreads at 176 bps, its level in1988, for the past 30 years. This allowed any changes in the “modified” index OAS to be driven purely by changing index rating weights.
By applying fixed spread levels to the changing index weights over time, the following chart shows that credit quality migration has resulted in the index OAS expanding from 116 bps at inception to 133 bps today. The “new neutral” level of the index OAS has drifted up by about 17 bps simply because index credit quality has deteriorated due the larger presence of BBB rated paper.
Implications for investors
If the current investment grade credit spread level of 108 bps vs. its historical average of 122 bps seems tight, it is. It stands 11% below its average. However, when accounting for the fact that the 108 bps historical average is reduced by a period when the index’s credit quality was much higher, we could make the argument that the historical “neutral” level should be 17 bps wider and stand at 133 bps. When viewed in this light, the current spread level of 108 bps seems even tighter by comparison, some 19% below the “new neutral” rate we calculated above.
Not ringing any alarm bells now, given corporate and economic growth remains strong. However, given this insight, fixed income investors should remain cognizant of spread implications when allocating to both non-investment and investment grade corporate debt. Impacts of credit changes in the investment grade space will become particularly important if there is a risk off event, as investment grade debt may sell-off more than usual given this change in rating composition. Throw in tighter monetary policy featuring higher rates that may lead to duration induced price declines, and there is a lot to think about in bond portfolio construction today.
To examine portfolio compositions and track the amount of credit risk in your portfolio, you can access our SPDR Portfolio Review Services by contacting your SPDR sales consultant at 866.787.2257. You can also obtain our brochure on portfolio analysis—currently, a service provided to investment professionals only.
Barclays US Credit Index
A benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate and government-related bond markets. It is composed of the U.S. Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
Basis Point (bps)
A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.
The difference in yield between a US Treasury bond and a debt security with the same maturity but of lesser quality.
Option Adjusted Spread or OAS
The measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.