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Credit Insights

Caution Signs for Corporate Bonds

While we still have a long way to tighten before we get to the historically tight spread levels before the credit crisis, we are starting to see developments that concern us.

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Investor demand for corporate bonds returned in earnest last week. Portfolio managers lengthened duration to take advantage of higher yields because of rising interest rates. Asset reallocation from municipal bonds and into corporate bonds also drove additional demand. The Morningstar Corporate Bond Index tightened 6 basis points to +138, the tightest level since April 2010.

For the past few months, the trading mantra on the Street has been to buy the dip. Considering that the dips in the market have become increasingly shallow and short-lived, the new trading mantra is to buy the pause. While we still have a long way to tighten before we get to the historically tight levels of spreads before the credit crisis, we are starting to see developments that cause us concern. For example, in the high-yield market, covenants are becoming diluted to the point where some restricted payment carveouts are large enough to drive a truck through. Underwriters are testing the waters to bring marginal issuers to market with pay-in-kind features. In the leveraged loan market, "covenant lite" deals are making a comeback.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.