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 is risk and has the potential to rival that of government securities.
12-Month Performance Following the Fed's First Interest-Rate Cut
Past performance does not guarantee future results. Source: Morningstar as of 7/31/24. Investment-grade corporate bonds represented by the Bloomberg US Corp Investment Grade Index, which measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds. U.S. Treasuries represented by the Bloomberg US Treasury Index, which is made up of U.S. government bonds of various durations.
Over the 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.
Corporate Debt vs. Treasuries and MBS Over Past 40 Years1
Past performance does not guarantee future results. Source: Morningstar as of 9/30/24. 1Growth of $10,000 investment. U.S. Treasuries represent the Bloomberg US Treasury Index, which includes public obligations of the U.S. Treasury with a remaining maturity of one year or more. Mortgage-backed securities (MBS) represent the Bloomberg Mortgage-Backed Securities Index, which is a market value-weighted index composed of agency mortgage-backed pass-through securities of the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac). Investment grade is represented by Bloomberg US Corporate Index, which covers performance for United States corporate bonds. High-yield bonds rep-resent the Bloomberg US Corporate High Yield Index, which measures the USD-denominated, high-yield, fixed-rate corporate bond market. High-yield/high-risk bonds (“junk bonds”) and floating-rate loans (usually rated below investment grade) have greater risk of default than higher-rated securities/higher-quality bonds that may have a lower yield. A risk-adjusted return measures the profit your investment has made relative to the amount of risk the investment has represented throughout a period. Yield is a measure of the profit that an investor will be paid for investing in a stock or a bond. It is usually computed on an annual basis.
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.
High CD Rates Historically Have Meant Higher Corporate-Bond Yields
Past performance does not guarantee future results. Source: Morningstar and Bankrate as of 6/30/24. A certificate of deposit (CD) is a type of savings account that pays a fixed interest rate on money held for an agreed-upon period of time. Investing in corporate debt funds carries various types of risks, including credit risk (defaults) and interest-rate risk (bond prices fall as rates rise). Short term investment grade credit is represented by the Bloomberg 1-3 Year US Credit Index, which measures the investment grade, fixed-rate, taxable corporate bond market and includes publicly issued securities that have between 1 and up to, but not including, 3 years to maturity. Investment-grade corporate bonds represent the Bloomberg US Corporate Investment Grade Index, which measures the investment-grade, U.S. dollar denominated, fixed-rate, taxable corporate and government-related bond markets.
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.
Returns in a Declining-Rate Environment
Past performance does not guarantee future results. Source: Morningstar as of 3/4/24. A certificate of deposit (CD) is a type of savings account that pays a fixed interest rate on money held for an agreed-upon period of time. Short-term corporate bonds represented by the Bloomberg 1-3 Year US Credit Index, which measures the investment grade, fixed-rate, taxable corporate bond market and includes publicly issued securities that have between 1 and up to, but not including, 3 years to maturity. Investment-grade corporate bonds represented by the Bloomberg US Corporate Investment Grade Index, which measures the investment-grade, U.S. dollar denominated, fixed-rate, taxable corporate and govern-ment-related bond markets. High-yield bonds represented by the Bloomberg US Corporate High Yield Index, which measures the USD-denominated, high-yield, fixed-rate corporate bond market. Intermediate core-plus bonds represented by the Bloomberg US Intermediate Corporate Bond Index, which measures the investment-grade, fixed-rate, taxable corporate bond market and includes publicly issued securities that have between 1 and up to, but not including, 10 years to maturity.
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.
Investors Have Benefited From Active Fixed-Income Management Over the Past 1, 3 and 5 Years
Past performance does not guarantee future results. Source: Morningstar as of 2/29/24. Active represents funds categorized by Morningstar as non-index funds, comprising 4,759 funds with an average net expense ratio of .84%. Passive represents funds categorized as index funds by Morningstar per the funds prospectus, comprising 541 funds with an average net expense ratio of .23%. Std Dev refers to standard deviation, which is a statistical measure representing the volatility or risk in an instrument. It represents the degree of spread or deviation of a set of values from their mean or average. Returns are annualized. Basis points, otherwise known as bps or “bips,” 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 in decimal form.
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).
Historical 12-Month Returns At Varying Price and Yield Levels
Past performance does not guarantee future results. Source: Bloomberg and Credit Suisse as of 1/31/24 *Current price or yield level. Yield is yield-to-worst (the lowest potential yield that can be received on a bond without the issuer defaulting) for investment-grade corporate bonds and high-yield bonds. Yield refers to yield-to-4-year life for bank loans which is the calculation of a bond's yield that is based on the average maturity of the bank loan issue. Bank Loans represented by the Credit Suisse Leveraged Loan Index, which is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. Investment-Grade Corporate Bonds represented by the Bloomberg US Credit Index, which measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets.
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?
Average Calendar-Year Returns When the Agg Has Been Negative
Past performance does not guarantee future results. Source: Morningstar as of 12/31/23. The Bloomberg Aggregate Bond Index broadly tracks the performance of the U.S. investment-grade bond market. U.S. Treasuries represented by the Bloomberg US Treasury Index, which is made up of U.S. government bonds of various durations. Mortgage-backed securities represented by the Bloomberg Mortgage-Backed Securities Index, a market value weighted index composed of agency mortgage-backed pass-through securities. Intermediate investment-Grade Corporate Bonds represented the Bloomberg US Intermediate Corporate Bond Index, which measures the investment-grade, fixed-rate, taxable corporate bond market and includes publicly issued securities that have between 1 and up to, but not including, 10 years to maturity. High-Yield Bonds represented by the Bloomberg US Corporate High Yield Index, which measures the USD-denominated, high-yield, fixed-rate corporate bond market. Bank loans represented by Credit Suisse Leveraged Loan Index, which is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market.
What Happened During the Last Soft Landing?
The last time the economy had a soft landing after a Federal Reserve ratehiking 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.
Returns From the Last Soft Landing After Fed Rate-Hiking Cycle (Feb. 1995 to Nov. 1998)
Past performance does not guarantee future results. Source: Morningstar as of 1/31/24. The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds. U.S. Treasuries represent the Bloomberg US Treasury Index, which is made up of U.S. government bonds of various durations. Mortgage-backed securities represent the Bloomberg Mortgage-Backed Securities Index, a market value-weighted index composed of agency mortgage-backed pass-through securities. Asset-backed securities represent the ABS companies of the Bloomberg US Aggregate Bond Index. Investment-grade corporate bonds represent the Bloomberg US Credit Index, which measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets.
Putting Default Worries in Perspective
Investor concern about defaults and distressed exchanges for high-yield bonds and leveraged loans may be overblown. Through the first nine months of 2024, there have been only 65 defaults/distressed exchanges for those asset classes for a default rate of 1.64% for high-yield bonds (historical average: 3.40%) and 3.70% for leveraged loans (historical average: 3.40%). Digging a bit deeper, much of the default and distressed-exchange activity this year (38%) and historically since 2008 (about 18%) came from repeat offenders, meaning many active managers would likely be leery of further investing in those names.
High-Yield and Leveraged-Loan Defaults and Distressed Exchanges (2020-Sept. 2024)
Source: JP Morgan as of 9/30/24. High-yield bonds (or junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds. Leveraged loans (also known as floating-rate loans or bank loans) are financial instruments that pays a variable or floating interest rate. A distressed exchange is proposed by a company to avoid a bankruptcy, improve liquidity, reduce debt, manage its maturity dates (by exchanging debt securities that are coming due for debt securities with an extended maturity).
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%.
Can BBB Corporate Bonds Help Make Up for the Agg's Poor Performance in 2021 and 2022?
Morningstar and Bloomberg as of 12/31/23. The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment grade bonds. Bond ratings are grades given to bonds that indicate their credit quality as determined by private independent rating services. Ratings are expressed as letters ranging from “AAA,” which is the highest grade, to “D.” Investment grade refers to a bond whose credit rating is BBB- or higher. BBB corporate bonds are represented by securities with a BBB credit rating in the Bloomberg U.S. Credit Index. A core fixed income strategy is a value-oriented fixed income strategy that invests primarily in a diversified mix of U.S. dollar-denominated investment-grade fixed income securities, particularly U.S. government, corporate, and securitized assets, including commercial mortgage-backed securities, residential mortgage-backed securities, and asset-backed securities. Total return is a performance measure that reflects the actual rate of return of an investment or a pool of investments over a given evaluation period. Price return is a measure of how the market value of the asset has changed, excluding any income received. Yield is defined as the income return (interest or dividends) on investment.
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