CIO INSIGHTS
SECO N D Q UARTER 2014 – FIXED I N CO M E
Corporate Bond Sector Correlations Encourage Active
Security Selection
In contrast to equity markets, where market correlations have come down
(referenced in our other CIO Insights this quarter), research from our Fixed
Income team suggests that sector correlations in the corporate bond market
have increased. We discuss what occurred, why, and what it means for
us and our clients.
Keys to Corporate Spread Compression
Interest rates and bond yields have remained
relatively low so far in 2014, particularly by
long-term historical standards. Furthermore,
in the corporate bond market, the difference
(spread) between the higher yields typically
associated with corporate bonds and the
lower yields associated with U.S. Treasury
securities of the same maturity compressed
to the lowest levels since before the 2008
Financial Crisis.
We believe this “corporate spread compression”
occurred for several fundamental and
technical reasons, including: 1) continued
economic recovery, 2) benign economic
conditions (low interest rates, low inflation),
3) solid corporate balance sheets, 4)
relatively low default rates for corporate
bonds, 5) relatively low volatility in the
corporate bond market, and 6) investor
demand for yield as well as diversification
out of government bond markets, where
there’s more perceived price risk from
the possibility of higher interest rates.
Corporate Correlations Increased as
Spreads Compressed
We believe demand for yield, in particular,
has driven down spreads across the
corporate bond spectrum, increasing
correlations between corporate sectors.
This is illustrated in the accompanying
graph, which shows how banking and
industrial sector spreads have converged to
the greatest extent since 2007.
What Does This Mean for Us and
Our Clients?
As referenced in our other CIO Insights this
quarter, we believe lower correlations in the
equity markets can provide opportunities for
active portfolio management and security
selection in those markets. At the same
time, we believe higher sector correlations
may have important implications for security
selection in the corporate bond market.
Spread compression and higher correlations
typically reduce return differentiation
between securities. But with spreads so
compressed, we can be particularly attentive
to individual higher-yielding securities that
we believe have currently resisted spread
compression because of temporary
technical factors like supply surges
or transitory fundamental events like
acquisitions that increase issuer debt levels.
And, looking ahead, as we potentially expand
and enhance our present fixed income
strategies, we are also evaluating yield and/
or appreciation opportunities in emerging
market corporate debt, European bank
debt, and structured loan-related securities
as part of both strategic and tactical
investment approaches.
Increasing Correlations Between Corporate Bond Sectors
Banking Spreads Minus Industrial Spreads
Spread Difference
(basis points)
300
200
100
0
-100
Source: Data calculated by POINT/Barclays Capital.© 2014 Barclays Capital Inc. Used with permission. Barclays Capital and POINT are registered trademarks of Barclays Capital Inc.
Data as of March 2014.
IN-FLY-81904 1403
©2014 American Century Proprietary Holdings, Inc. All rights reserved.
G. David MacEwen
Co-Chief Investment Officer
Spread is the difference in yield
between a bond from a sector with
typically higher yields and a bond of
the same maturity from a sector with
typically lower yields. In the U.S. market,
the lower-yielding “base” bond sector
is usually U.S. Treasuries. Corporate
spreads are the difference in yield
between U.S. corporate bonds and
U.S. Treasuries of the same maturity.
When these spreads narrow, they are
said to compress.
The graph shows how the spreads
for two of the biggest corporate bond
sectors have become increasingly
similar (the difference between them
has declined to near zero), illustrating
the increasing correlation. Generally,
as interest rates rise, bond values will
decline. The opposite is true when
interest rates decline.
Chart data derived from average
Industrial and Banking sector spreads
from subindices of the Barclays U.S.
Credit Index, which consists of publicly
issued U.S. corporate and specified
foreign debentures that are registered
with the Securities and Exchange
Commission and meet specific maturity,
liquidity, and quality requirements. The
index includes both corporate and noncorporate sectors. The corporate sectors
of the index are Industrial, Utility and
Finance (which includes the Banking
subsector).
One basis point equals 0.01%.
The opinions expressed are those of G.
David MacEwen and are no guarantee of
the future performance of any American
Century Investments portfolio.
For educational use only. This information is
not intended to serve as investment advice.
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