Is a yield bubble forming in corporate bonds?

Government bond yields have been steadily declining in recent weeks, in turn dragging corporate bond yields ever lower.

Investors that have been drawn to the relative stability of corporate bonds during the crisis will at some point say enough is enough.

How low can yields go before investors look elsewhere for income?

During the darkest days of the credit crisis at the start of 2009 corporate bond yields spiked to levels not seen for many years.

Only the very brave took advantage of this opportunity at first, but yields remained attractively high throughout 2009 and into 2010.

This encouraged a significant flow of funds into the asset class looking for the middle ground between the safety of government bonds and more volatile equity markets.

Indeed, ongoing demand has been a major driver of the strong performance of corporate bonds in recent quarters.

As the graph below shows, the yield on offer from corporate bonds has become less attractive in recent months.

The main driver behind this has been falling government bond yields. Nevertheless, while the yield premium (the additional yield investors receive for holding corporate bonds) has also been declining, it remains attractive versus pre-crisis levels.

Whatever the cause of the decline, there may come a time when yields get too low to attract new investors. However, it doesn’t appear that we’re quite there yet.

While some way from the peak in 2009, inflows to corporate bond funds remain strong, and should remain so as long as the propensity to chase historical performance remains in place.