The spreads between investment-grade and speculative-grade bonds and U.S. Treasuries have shrunk to record lows, according to a new report from Standard & Poor’s.
Thanks to strong inflows from foreign investors and alternative investor demand, the spreads — that is, the additional yield over comparable Treasuries that corporations must provide investors — declined steadily from 2003 to 2004 and have hovered in a tight range ever since.
“Borrowers have taken advantage of the cheap money by increasing leverage to finance dividend recapitalizations, share buybacks, and M&A,” said Diane Vazza, head of Standard & Poor’s Global Fixed Income Research Group, in a press release. “With spreads compressed across all rating categories, the cost of maintaining an investment-grade rating no longer affords firms a significant cost advantage.”
For example, wrote S&P, from 2003 to 2005 investment-grade spreads slid close to 100 basis points; during the past 12 months, they have averaged 133 basis points.
The spread for speculative-grade debt has also contracted sharply, from 800 basis points in January 2003 to about 340 basis points during the past 12 months. For the first three weeks of this month, speculative-grade spreads have remained under 300 basis points.
The credit-rating firm also projected, however, that the 12-month trailing speculative-grade default rate will reach 2.3 percent by year-end. As a result, it expects speculative-grade spreads will widen to between 350 and 375 basis points.
In addition, S&P pointed out that the quality premium — the difference in the cost of borrowing between corporations with investment-grade credit and with speculative-grade credit — has fallen 600 basis points over the past four years, to about 160 basis points. “With the cost of financing declining across all rating levels, corporations have been more willing to use leverage to achieve their business goals,” noted Vazza.