There has been a dramatic swing in the yield-spread relationsips between different quality-rated corporate bonds versus U.S. Treasuries, as well as between the issues of the different quality-rating categories themselves. These changes have not only been caused by cyclical swings in the economy and interest rates, but in changing events within the financial markets themselves.
Interest rates were at their peaks during the first half of 1982. During this period, yield spreads were at their widest, following a familiar cyclical pattern. At that kind of juncture, as the economy slips into recession, investors typically become concerned about the viability or creditworthiness of corporations, and concentrate on purchasing quality issues. Then, during the transition period from recession to recovery, interest rates fall. At this point, investors reason that the worst is over and begin to buy securities with the highest available yield. This is the main cause for the closing of the spreads.
In April 1981, low grade, long-term B-rated industrials returned between 325 to 450 basis points more yield than a Treasury with the same maturity. (A basis point is 1/100th of a percentage point.) A year later, that spread had widened to 600 basis points. Today, that spread had narrowed to 250 to 275 basis points.
Similarly, BBB-rated public utilities were returning 250 basis points more yield than a comparable long-term Treasury in 1981. By 1982, that spread had expanded to 400 to 450 basis points and by this month, the spread had compressed to 200 basis points.
Currently, two other factors have played a big part in this spread contraction. During the past year, insurance companies have sold billions of dollars worth of annuities with guaranteed rates of return.In order to cover these guarantees, insurance companies have become big buyers of high-yielding bonds with low ratings.
Further, savings and loan associations have just recently been authorized to purchase BB-rated bonds. With billions flowing into their money market deposit accounts and super NOW accounts, they have begun to purchase lower rated securities. In a similar fashion and for the same reasons, the S&Ls also helped to compress the spreads between the top grades of commercial paper from 125 basis points in 1982 to the current 38 basis points. The hectic demand for yield has also compressed the spreads between the different bond ratings categories.
The fortunes of each company can be a story in itself. In 1981, when the Ford Motor Credit Co. was on shaky ground, but was still rated AA, it returned 300 basis points more yield than a Treasury. One year later, after it had been downgraded to a BBB rating, the spread widened to 660 basis points. Today, after credit fears have abated, the spread has narrowed to 175 basis points.
During the past four years, the "low rated" or "junk bond" market has gained acceptance and a large following. Some analysts say they would rather buy a strong B or BB rated issue rather than a weak A- or BBB-rated company whose future is unknown.
For qualaity buyers, the Treasury will offer a two-year note on Wednesday in minimums of $5,000. They should return 9.375 percent.