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Watch credit quality as spreads narrow

Fixed-income investors need to examine the credit quality of their bonds and be sure they’re getting paid for the risk they’re taking, as Marc Amateis explains.

Joel Dresang: Marc, let’s talk about bonds. I’m hearing more that we have to worry about the credit quality on the fixed-income side of our portfolio. First of all, remind us what we mean when we talk about credit quality.

Marc Amateis: Sure, Joel. Well, let’s start with what a bond is. When you buy a bond, what you’re really doing is loaning your money to an entity, be it a government in the case of Treasurys, or to a company, in the case of corporate bonds.

And when you do that, you want to make sure not only do you get paid the income stream that you’re due on that bond, but also you get paid back at the end. And that’s what credit quality tells you, is how likely are you to be paid back on the bond.

Joel: So, let’s look at the spread in the yields that you would get from higher quality bonds versus lower quality bonds. Why is that important?

Marc: Well, it’s important because you’re taking more risk on the lower quality bond and you’re taking less risk on a higher quality bond. So you want a reasonable spread in yield between those two. You know, if the spread is too narrow, you’re not getting paid enough to take the extra risk on the lower quality bond.

Right now, the spread between high yield, or junk bonds, and high quality, investment-grade credit is relatively narrow, meaning you don’t get that much more for the risk that you’re taking when you’re going out there and buying a low quality bond.

Joel: What’s behind the narrowing of the spreads on those bonds?

Marc: Well, a couple things are at work. When spreads narrow, it often means the economy is doing very well, so investors feel more secure that they’re going to be paid back on those lower quality bonds. But in addition, in a low interest rate, low yield world, like we’ve been in for some time, investors are stretching for yield. They’re maybe investing in things that they normally wouldn’t because they have to get a higher rate of return.

Joel: So what do those narrowing spreads mean for investors?

Marc: Well that means, number one, that you’re not getting paid as much for the risk on those lower quality bonds as you are when spreads are wider.

But it also means that you need to focus in on why you own bonds in the first place, and that is for safety and income. And that means higher credit quality. So you want to take most of your risk on the stock side of your portfolio and make sure that you don’t overdo the risk on the bond side.

Joel: How do I know what the credit quality is of the bonds that I have in my portfolio?

Marc: Well Joel, most bonds are rated by one of the two rating agencies, Moody’s or S&P. And that rating will show up in the prospectus of a bond fund or the bond offering of an individual bond. Now here at Landaas, we use the Morningstar snapshot, and that actually looks inside the bond funds that we use and breaks out the credit quality so we know exactly what kind of credit quality an investor has in their overall bond portfolio.

Joel: So why don’t I just put all of my bond holdings in the safest, in AAA?

Marc: I don’t think you want to do that for a couple reasons.

Number one, there is opportunity to get higher yields in medium and lower quality bonds. You just have to do it reasonably and be careful.

But number two also, you want the diversification that that offers. If you’re all in highest AAA quality, then chances are you’re by far mostly in U.S. Treasurys. And again, you want some diversification in your bond portfolio, just like you want it in your stock portfolio.

Learn more
An approach to bonds amid rising rates, a Money Talk Video with Marc Amateis
Bond investors, look at credit quality, spreads, a Money Talk Video with Marc Amateis
How bonds fared as Fed has raised rates, a Money Talk Video with Kyle Tetting
Tips Before You Invest in Bonds, from the Financial Industry Regulatory Authority

Marc Amateis is a vice president and investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Jason Scuglik and Peter May

(initially posted Nov. 6, 2017)

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