Insight

From farming to hunting and back again

From farming to hunting and back again

Finding income doesn’t have to be so risky anymore

Bond investing used to be like farming: buy a portfolio of relatively high quality securities, tend to it, and harvest the coupons over a multi-year horizon.

The Global Financial Crisis of 2008 changed that as more than a decade of low or negative central bank policy rates forced investors to adapt. A more active, hunting approach was needed to find real returns in the bond market, and this brought with it a greater degree of risk. Achieving returns over 3% generally required some allocation to sub-investment grade and / or emerging market bonds. These brought with them periodic waves of default, as we saw for example in 2015-2016 in the energy sector and 2021-2022 in Chinese real estate. While decent total returns could be earned with the hunting approach, they were rarely smooth and often below initial expectations.

The developments over 2022 have reopened the door for the farming approach, however. As central banks have raised interest rates at the fastest pace in 40 years, we find ourselves with a more generous level of yield in the bond markets. If we look at the yield to worst on the global investment grade corporate index, we see that, not only is it at the highest level since 2009, but it is also around the prevailing levels for high yield and emerging market debt for much of the 2014-2021 period.

Yield to worst on selected asset classes, %

Source: Bloomberg, to January 2023. Indices used: Bloomberg Global Aggregate Corporate, Bloomberg High Yield Corporate, Bloomberg EM Sovereign (Hard Currency), Bloomberg EM Corporate (Hard Currency). Past performance does not predict future returns. 

The added advantage for investment grade is that the prospects of realising those yields are much higher now. If we look at historical default rates, the highest annual rate for global investment grade corporates was just 0.4% in 2002 and 2008, while for high yield it has historically been 10% or more. 

Annual default rates (%)

Source: S&P 2021 Annual Global Corporate Default and Rating Transition Study. Past performance does not predict future returns. 

This suggests that the probability of realising permanent capital losses in an investment grade portfolio is low, though there will likely be some volatility in mark-to-market performance as the level of yields fluctuates. Nevertheless, if one is willing to be patient and farm the portfolio, one can have reasonable confidence in achieving yields to maturity, particularly when combined with issuer diversification and investment decisions underpinned by robust bottom-up credit analysis.

As bond markets are anticipating further rate hikes by most major central banks, yields are currently highest for shorter maturities. If we consider a 3- or 5-year target maturity investment grade corporate portfolio, the index yield to worst is 4.5-5%1, while the effective duration is three years. At Invesco, we can further optimise a portfolio for potential returns, thanks to our proprietary Vision analytics system.

The chief risks for mark-to-market performance are 1) central banks could fail to get inflation under control and further rate hikes could be needed – this would be mitigated by the short duration and “pull to par” effect, which allows the opportunity to reinvest the proceeds at more attractive yields at maturity; 2) weaker than expected growth could detract from corporate fundamentals and prompt spreads to widen – again this would be mitigated by a short duration, high credit quality portfolio for which  diligent credit research and diversification would help reduce the chances of capital impairment. The shorter maturity focus also increases research visibility and should reduce the need for subsequent portfolio turnover.

Overall, we view current conditions as favourable for investment grade corporate bonds, particularly in the shorter maturity space, which offer the chance to harvest yields previously reserved for high yield and emerging markets, but with lower credit and interest rate risk.  

FOOTNOTES

  • 1

    Based on the ICE BofA ML 3-5y US Corporate (C2A0) and Global Corporate (G2BC) indices. Source: Bloomberg, February 2023.

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