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Investment-Grade Bonds and Spreads
Are today’s option-adjusted spreads for investment-grade corporate bonds at 84 basis points1 too tight? Well, consider this. They are still well above their record low of 51 basis points, and the past four times that spreads were at current levels:
•They continued to tighten on average for another 25 months on average;
•It took an average of 36 months for spreads to return to their long-term average of 120 basis points;
•Investment-grade corporate bonds had an average price ($106.76), well above where they stand today($95.97)1; and
•They had an average yield (4.25%), well below today’s level (4.67%). 1
Past performance does not guarantee future results. Investing involves risk, including loss of principal. The four periods when spreads were at 84 basis points were 1/29/93, 9/30/04, 10/31/05, and 2/26/21. Investment-grade corporate bonds are represented by the Bloomberg US Credit Index, which measures the performance of U.S. investment-trade taxable corporate, fixed-rate, and government-related fixed-income securities. Investment grade refers to the quality of a company's credit. To be considered an investment grade issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody’s. Basis points (bps) are a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001. The option-adjusted spread (OAS) measures the difference in yield between a bond with an embedded option with the yield on Treasuries. Embedded options are provisions included with some fixed-income securities that allow the investor or the issuer to do specific actions, such as calling back the issue.
Over Long Run, Corporate Debt Has Outperformed Treasuries and MBS
Historically, the additional yield offered by corporate debt has paid off for patient investors. Corporate debt has outperformed two of its more conservative fixed-income counterparts—U.S. Treasuries and mortgage-backed securities (MBS)—over the past 40 rolling 10-year periods. Investment-grade corporate bonds outpaced those two asset classes 94% of the time, and high yield outperformed them 91% of the time. Not only that, over the past 10 rolling 10-year periods, investment-grade corporate bonds and high-yield bonds have generated a positive risk-adjusted return of 0.21% and 0.45%, respectively, vs. -0.04% for Treasuries and -0.03% for mortgage-backed securities.
Performance of IG Bonds After 1st Rate Cut
In five of the six latest rate-cutting cycles, investment-grade (IG) corporate bonds have outperformed the Bloomberg US Aggregate Bond Index (Agg) and the Bloomberg US Treasury Index the 12 months following the first rate cut by an average of 3.25% and 4.33%, respectively. And with only 11 investment-grade corporate bond defaults in 25 years, these higher returns have historically come with low levels of risk that rival that of government securities.
ESG Fixed Income Has Outperformed
While some investors may think environmental, social, and governance (ESG) investing equates to lower returns, ESG fixed-income investments over the past decade have outperformed the Bloomberg US Aggregate Bond Index and broad investment-grade corporate bonds.
Performance of CDs After Rates Peak
While certificate of deposit (CD) rates have dramatically risen since early 2022, history has shown they decline just as rapidly. In the six times since 1984 when CD rates peaked, returns have declined in the following year by an average of 28%. During these periods, many corporate fixed-income sectors have outperformed CDs by a wide margin.
Yields: Fixed Income Now Well Above Equities
With today’s fixed-income yields being at higher levels than in recent years, they can offer equity-like returns without the extra volatility of equities. Over the past 25 years, equities have had a higher return, but this also came with much more volatility. Now with fixed-income yields at their current levels, investors may be able to capitalize on higher returns at lower levels of risk.
Bank Loans vs. The Agg
While some investors think bank loans only do well when risk assets have rallied, historically the asset class has outperformed the Bloomberg US Aggregate Bond Index (Agg) in good times and bad. Looking at rolling two-year returns after the Global Financial Crisis of 2007-2008, when the Agg has returned 0% or less or 5.1% or more, bank loans have outperformed the index by an average of 9.30% and 1.03%, respectively. And when returns for the Agg were between 0.01% to 3.0%, bank loans have also outperformed the index by 3.74%.
Why Short-Term Credit
Some investors have shifted to longer-duration fixed income in hopes of capitalizing on a potential market downturn, but shorter duration credit has outperformed the Bloomberg US Aggregate Bond Index so far this year as economic growth has been resilient. For advisors ready to move beyond cash, short-term credit may present a compelling opportunity. A slight extension in duration may help reduce the reinvestment risk of cash while providing some diversification to riskier assets and similar yield than longer-duration fixed income.
Duration and Investment-Grade Bonds
Historically, investment-grade corporate bonds have carried a longer duration (6.2 years) than the Bloomberg US Aggregate Bond Index (5 years). The majority of that 24% increase in duration has come from lower-quality investment-grade tranches and not from higher-quality names included in the Agg. Currently, 43% of the duration of investment-grade corporate bonds comes from BBB credits vs. just 14% for the Bloomberg US Aggregate Bond Index. Investors interested in adding duration may want to look at their asset-class makeup to see where the duration is coming from.
The Risks of CDs
Certificate of deposits (CDs) don’t carry many of the traditional risks of fixed income, but they do have some, including:
- Less Purchasing Power: CDs do not adjust to increases in interest rates and inflation like some areas of fixed income, which leads to less real-purchasing power for investors.
- No Capital Appreciation: While some areas of fixed income will see price increases when interest rates fall, CD investors do not benefit from capital appreciation.
- Lack of Liquidity: While some CDs offer an out for investors, to do so does incur a stiff penalty for investors to access their cash.
- Lower Returns: Historically, when CD rates have been high, corporate bond yields have been even higher.
How Corporate Bonds Fared in Best, Worst Years
While many investors have sought safety in the Bloomberg US Aggregate Bond Index (Agg) in difficult times, others have fled broad investment-grade bonds during risk-on and rising interest-rate environments. Looking at the five best and five worst annual returns of the Agg since 1991, intermediate investment-grade corporate bonds and high-yield bonds have performed about as well or better than broad investment-grade bonds.
The Shift in Risk Profile of Bank Loans
While some investors may dwell on their experience in the bank-loan market during the Global Financial Crisis of 2007-2009, the loan market today, as measured by the Credit Suisse Leverage Loan Index, contains larger, more liquid issues, as well as fewer below investment-grade companies.
Active vs. Passive Fixed-Income Management
While taxable fixed-income flows have dramatically favored passive-based strategies over the past 12 months ($228 billion have flowed into passive fixed income vs. $33 billion for active fixed income), given the 147 basis points of outperformance by active fixed income over the period, investors have left quite a bit of money on the table in the amount of $3.36 billion. Then when you go back over the past three years, investors have also lost almost four times more in passive fixed-income strategies. In dollars, passive fixed-income investors have lost almost $10.71 billion more due to their choice of selecting a passive fixed-income option over an active fixed-income solution. While investors might be choosing passive fixed-income strategies due to their less expensive price tag, this might be costing investors quite a bit more in the long run if this return pattern continues.
Investment-Grade Corporate Bonds Present Opportunity
Investment-grade corporate bonds have historically compensated investors for the additional default risk relative to other investment-grade fixed-income sectors as shown by the option-adjusted spread. Even in difficult times, the worst-case scenario of a company default has rarely occurred in investment-grade corporate bonds. The asset class had only 11 defaults over the past 25 years, despite averaging 5,127 issues over the same period.
High-Yield Spreads Towering Over Default Rates
Credit spreads exist to compensate investors for the extra risk they are taking in purchasing a credit-risky bond over a risk-free bond. One might assume that the average credit spread should be similar to the average default rates because default risk along with downgrade risk is what investors are getting paid for. History shows that this is not the case in the high-yield market. When looking at average credit spreads over the past 25 years, one can observe that the average BB, B and CCC spreads are all comfortably above their respective average default rates (by rating 12 months prior to default) of the past 25 years. This makes the case that investors are getting compensated above what they should be for the default risk.
Is Now the Time to Rethink Fixed-Income Core?
Since 1976, intermediate core bond funds that closely followed the Bloomberg US Aggregate Bond Index underperformed compared to more versatile intermediate core-plus bond funds. Intermediate core plus bond funds generated 17.5% more growth since 1976, and over the past 20 years, generated a higher return, higher risk-adjusted returns, a lower drawdown in difficult times, and better up/down capture ratios relative to the Bloomberg US Aggregate Bond Index. This can be attributed to intermediate core plus bond funds greater tendency to invest in spread sectors and non-investment-grade fixed income, hence the reason “plus” was added to the naming convention of the Morningstar category.
Positive History for Fixed Income
Since 1976, the Bloomberg Aggregate Bond Index has had its fill of intra-year declines, but it still has managed to finish the year in positive territory the majority of the time. Since the inception of the index, history shows that bear markets for bonds are not as steep as some may make it out to be, as the average calendar year drawdown is just 2.6% per year vs. an average decline in equities of 14.2%. Further, following bad years of performance, bonds have historically tended to deliver strong results.
IG Credit, the Agg and Outperformance
Since 1990, the Bloomberg US Aggregate Bond Index (Agg) has outperformed intermediate investment-grade corporate bonds in 12 of the 33 years. In the year after the corporate bonds’ underperformance, the asset class has outperformed the Agg in 9 of the 12 instances by an average of 1.16%. If investors turn to the Agg for lower risk, they may risk missing out on a quick recovery of corporate bonds.
Catching Up With IG Corporate Bonds
Historic negative returns for the Bloomberg US Aggregate Bond Index (Agg) have left investors with a 3-year cumulative return of -11.14% vs. -4.44% for intermediate investment-grade corporate bonds. To make up for the Agg’s losses, the index would need to produce a return of 12.53%, but that number falls to just 4.65% for the corporate bonds. Over the past 30 years the Agg has only produced a calendar year return greater than 12.53% once (or 3.3% of the time). On the other hand, intermediate investment-grade corporate bonds have produced a calendar year return of 4.65% or greater (50% of the time).
IG Returns Amid Falling Interest Rates
While some investors—uncertain about the Federal Reserve’s next moves—have recently migrated to the low risk of money-market funds or short-term bond funds, they may miss out if interest rates start to decline. With their added duration, intermediate-term fixed-income funds have historically provided more upside potential than money-market funds or short-term bond funds when rates start to drop.
High-Yield Bonds: Returns, Volatility and Risk
Over the past three years, high-yield bonds have outperformed the Bloomberg US Aggregate Bond Index, global bonds and emerging-market debt. During the same period, volatility for high-yield bonds has been below average compared to the asset class’s 20-year average (trailing 3-year standard deviation finished January 2024 at 8.36 vs. 9.13 for the 20-year average). Also, compared to global bonds and emerging-market debt—other asset classes investors turn to for yield—high-yield bonds have seen subdued levels of volatility over the past three years. While some investors may be concerned about a pickup in default activity for high-yield bonds, this increase has been mostly seen in lower quality bonds, which make up just 13.2% of the asset class.
Corporate Bonds vs. Diversified Bond Portfolio
When looking back at how corporate bonds and an equally weighted corporate-bond portfolio would have done over rolling 3-year periods since 1994, the balanced portfolio would’ve generated 20% more return with only 2% more volatility. More importantly, broad investment-grade bonds have significantly underperformed corporate bonds in difficult periods for investors. For example, a diversified portfolio of corporate bonds would’ve protected investor portfolios better over the 15 years since the Global Financial Crisis (2007-2009) vs. the 15 years prior to the Global Financial Crisis.
Keeping up with the Changing Fixed-Income Market
Back in 1993, the Bloomberg US Aggregate Bond Index was made up of 6,074 issues, had a market value of $3.9 trillion and, dating back to 1976, had never experienced negative returns in two consecutive calendar years. Today, the investment-grade bond market is made up of 13,417 issues, has a market value of $26.51 trillion and just recently experienced its first negative returns in consecutive years. With how much the fixed-income market has changed over three decades, is it time for a different investment approach and to consider corporate bonds?
Is the Time Right for Corporate Debt?
Historically, when investment-grade corporate bonds, high-yield bonds and bank loans have reached the same price and yield levels as today's, they've generated a 12-month return well above each asset class’s 20-year annualized return (6.49% for high-yield bonds; 3.96% for investment-grade corporate bonds; and 4.74% for bank loans).
What Happened During the Last Soft Landing?
The last time the economy had a soft landing after a Federal Reserve rate-hiking cycle occurred in 1995. In the nearly four years after the end of that rate hiking cycle when the Fed held rates relatively stable, investment-grade corporate bonds outperformed many fixed-income asset classes. The Fed’s current hiking cycle, which to date has closely paralleled the one in the mid-1990s, may have the economy coming in for a similar soft landing. If the economy continues on this path, corporate credit may be an attractive option for investors who are looking to find more yield.
The March Toward Added Duration
While intermediate-term fixed-income funds saw approximately $186 billion in inflows in 2023, this was dwarfed by the $959 billion of inflows into money-market funds (a 24% increase from 2022). With money-market fund assets under management (AUM) near historic levels, could fixed income see a wave of inflows into duration in 2024 in anticipation of the Federal Reserve potentially cutting rates?
Completing the IG Total-Return Equation
While yield levels remain elevated across fixed-income asset classes, investment-grade corporate bonds may have some price appreciation left for 2024. Historically1, when investment-grade corporate bond yields have been within 25 basis points or 50 basis points of current levels, the average price of the asset class has been 8.7% and 9.0% higher, respectively, than current levels, completing the other half of the total-return equation.
Can BBB Yields Make Up for Agg Losses?
Despite a rally last year in fixed income, many investors may find themselves in a hole when it comes to their core fixed-income position with the total return for the Bloomberg US Aggregate Bond index over the past three years at -9.62%. When you back out yield and just look at price return, those returns fall to -16.70%. Though the index yield still sits near a multi-decade high of 4.53%, it could take over two years for investors to see positive returns on core fixed-income positions added three years go. On the other hand, BBB investment-grade corporate bonds could help shorten that breakeven period, as BBB corporates started the year with a yield of 5.28%.
Past performance does not guarantee future results. Investing involves risk, including loss of principal.
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Intermediate IG Bond Performance vs. the Agg
While some investors would think that intermediate investment-grade (IG) corporate bonds only do well when risk assets have rallied, historically the asset class has outperformed the Bloomberg US Aggregate Bond Index (Agg) in both good times and bad. Looking at rolling three-year return periods, when the Agg has returned 0% or less, intermediate investment-grade corporate bonds have outperformed the index by an average of 2.01%. And when returns for the Agg has returned 5% or more, intermediate investment-grade corporate bonds have outperformed the Agg by 0.77%.
The Resiliency of Bank Loans
The common perception of many investors is that bank loans (or floating-rate loans) only outperform in periods of rising rates. A less frequently discussed topic is how the asset class performs in periods of flat and declining rate environments.
How IG Bonds Have Fared Compared to a Diversified Bond Index
With investment-grade corporate bonds, investors might have the opportunity to capture higher yields and potential excess return compared to a diversified bond index. Since 1981, the Bloomberg US Corporate Investment Grade Index has generated:
• A higher 3-year rolling return than the Bloomberg US Aggregate Bond Index 77.5% of the time.
• Seven periods of a 3-year rolling return greater than 19% compared to just two from the Bloomberg US Aggregate Bond Index.
• Only four periods of a 3-year rolling return less than -1% compared to six periods from the Bloomberg US Aggregate Bond Index.
What Might Happen if the Fed Lowers Rates?
Bond prices have an inverse relationship to yield: When yield or interest rates increase or decrease, bond prices move in the other direction. By looking at the duration of an asset class, you can potentially estimate how much bond prices might move for every 1% shift in interest rates. Then you could add in the current yield to estimate the potential 12-month return. With the Federal Reserve now on pause, and the market likely anticipating rate cuts in 2024, here is a look at what the potential return might be for specific investment-grade fixed-income asset classes based off current duration and yield levels if the Fed decreased interest rates by 1%.
How Did Intermediate IG Bonds Perform After the Fed's Last Pause in 2018?
In the 12 months following the Federal Reserve’s last rate hike in December 2018, intermediate investment-grade corporate bonds outperformed the Bloomberg US Aggregate Bond Index by 1.42%. In addition to the higher returns, intermediate investment-grade corporate bonds also generated during this period 28% less volatility than the Bloomberg US Aggregate Bond Index; 57% less max drawdown than the Bloomberg US Aggregate Bond Index; and higher returns in the best and worst quarter than the Bloomberg US Aggregate Bond Index.
Why Now May Be the Time for Tax-Loss Harvesting
Since most fixed-income funds distribute the majority of their return in the form of monthly distributions, their price return is usually well below the total return. For example, the Bloomberg US Aggregate Bond Index has generated a price return of -2.67% over the trailing 12 months and -11.74% over the past five years. On the other hand, the total return for the index (adding distributions and capital gains) was 0.64% for the trailing 12 months and 0.51% for the past five years. Knowing this, investors may want to take advantage of the current environment and consider tax-loss harvesting their fixed-income losses from what have historically been considered conservative investment options.
Not All Yield Comes With Large Volatility
Historically, higher levels of yield meant higher levels of volatility. However, this has not been the case with bank loans. Over the past three years, bank loans have had lower levels of volatility with higher levels of yield compared to most investment-grade, fixed-income asset classes.
The Spike in Personal Savings Has Disappeared
Thanks to the COVID relief programs, personal savings soared in 2020 and 2021, peaking at $6.5 trillion (about a 364% increase from historical levels). But over the past two years, those excess savings—which many have credited with helping keep the economy strong—have been spent.
After a Hiking Cycle, Longer Duration Has Historically Outperformed Shorter Duration
Historically, intermediate core plus bond funds have significantly outperformed money market and ultra short bond funds in the 12 months following a Federal Reserve hiking cycle, as longer duration bond investors have benefited from higher yields and more attractive relative value. While investors have added $614.1 billion to money market funds so far in 2023, there may be a better investment opportunity with longer duration assets should the Federal Reserve decide to take a pause in the current rate hiking cycle.
How Corporate Debt Performed Last Hiking Cycle
Corporate debt had strong returns during the previous Federal Reserve rate-hike cycle ending in 2018, continued to have strong returns through the pause, and outperformed other asset classes through the full cycle.
Why Duration After a Rate-Hiking Cycle Ends
Historically, when a Federal Reserve rate-hiking cycle has ended, longer-duration spread sectors have materially outperformed more traditional fixed-income and shorter-duration spread sectors in the following 12 months.
Yields Across Corporate Credit Have Been Rising
Yields across corporate credit are currently far higher than at the end of 2021. In this environment, the additional credit risk may be worth the additional yield for investors.
What Happened After Fed Last Paused Rate Hikes?
The Federal Reserve has predicted it will raise interest rates two more times in 2023. But current market expectations are for a rate pause for the rest of the year. Here's what happened the last time the Fed paused rates.
Year-Over-Year Consumer Spending Trends
Consumer spending has been slightly up year-over-year (as of July 22, 2023), according to Bank of America credit-card spending data. While spending was significantly down in categories such as online electronics, furniture and gas, consumers have been paying more on dining and entertainment.
Yield, Volatility and Bank Loans
Historically, if investors wanted higher levels of yield, they would have to take on higher levels of volatility. But over the past three-plus years, bank loans have had lower levels of volatility than most investment-grade areas of the fixed-income market with higher levels of yield. Bank loans currently offer investors more than two times the yield of the Bloomberg US Aggregate Bond Index, while having delivered 50% less volatility over the past three years.
Longer Duration, Smaller Yield so far in 2023
Over the past 12 months, longer-duration asset classes have seen $99.4 billion in net inflows vs. $22.8 billion in outflows from shorter-duration categories.1 To date, this move to duration—sparked largely by the potential ending of rate hikes by the Fed—has seen bank-loan funds outperform long government bond, intermediate core bond and intermediate government bond funds in the second half of 2022, all of 2022 and 2023 year-to-date.
Yields Across Corporate Credit Have Been Rising
With yields across corporate credit currently far higher than at the end of 2021, investors may now assess whether additional credit risk has been worth the extra pickup in yield.
Duration, Yield and Fed Expectations
Some investors have started to add duration to their fixed-income investments, expecting a Federal Reserve pause in interest-rate hikes. But given the current curve inversion across various areas of fixed income, investors have been giving up yield for the sake of adding duration. With the Fed still reiterating a data-dependent approach, investors may be caught off guard if the Fed continues to raise rates without a pause.
Is it Time to Revisit Bank Loans?
In 2022, investors had few places to hide amid one of the worst market years on record. But one fixed-income asset class performed far better than others: Bank loans.
Short-Term vs. Intermediate Core Bonds
Fixed-income investors in intermediate core bond funds gave back 105% and 71% of their 5-year and 10-year return, respectively, in 2022. Investors who added exposure to short-term bond funds fared better; the average short-term bond fund finished 2022 with a return of -5.22% vs. -13.32% for the average intermediate core bond fund. This was the greatest margin of outperformance for short-term bond funds over intermediate core bond funds since the inception of the Morningstar Short Term Bond Category.
How Have Bank Loans Performed in Down Years?
In 2022, investors had few places to hide amid one of the worst market years on record. But one fixed-income asset class performed far better than others: Bank loans.