Investment grade credit: quality meets opportunity

Introduction

After a savage bond selloff in 2022, we believe fixed income markets are now offering good income opportunities at attractive valuations for the first time since the global financial crisis. Against this backdrop, many investors have been increasing the size of their fixed income allocation.

But which areas of the bond universe look most compelling?

Fixed income ETF flows can be a good indicator of investor sentiment, helping to highlight those parts of the market that look most attractive to investors at a particular point in time. If we look at recent data, we can see that investment grade credit has seen particularly strong inflows in recent months.

While government bond allocations dominated fixed income ETF flows for the first nine months of 2022, investor sentiment started to change in the final quarter of the year, when investment grade (IG) credit began leading the pack.

This shift towards IG credit at the end of 2022 was perhaps unsurprising. Heightened geopolitical tensions and fears of a global economic slowdown had driven spreads considerably wider, creating an attractive entry level for investors.

Where are we now, and is IG credit still attractive?

Since the beginning of 2023, global economic sentiment has shifted slightly in tone to become more positive. Concerns about a recession have started to wane, as economies have appeared more resilient than expected.

As talk of a soft landing has returned, investment grade spreads have tightened, meaning that the income opportunity isn’t quite as good as it was at the end of 2022. However, we believe that IG credit still looks compelling for several key reasons:

The global economy is not out of the woods just yet

While the data has been better than expected recently in Europe, supported by falling gas prices and the reopening of China, the risk of recession is not yet off the table, and we are yet to see the full impact of previous rate hikes.

Against this backdrop, a more defensive asset class like IG credit could prove more attractive than higher yielding assets.

Yields are still very compelling

Despite the strong rally in January, yields on the asset class retraced in February and are still at highs not seen since 2009. Flows and corporate fundamentals remain broadly supportive. At 5%, the yield on global investment grade is close to that previously seen for high yield and emerging markets over much of the last decade.¹

Corporate bond returns are typically strong 12 months after the cycle low

While rates now look like they may be peaking, with markets rallying in January, now could still be an attractive entry point.

Take a look at Figure 1, which plots corporate bond returns over a period of over 50 years, detailing the highs and lows. The grey shading draws attention to the 12-month periods following major lows.

As you can see, historically, corporate bond returns have been strongly positive for a sustained period following major market selloffs.

With this in mind, we take a closer look at the asset class, assessing its key features, benefits and risks. We also share some case studies and outline how IG credit behaves across a full market cycle.  

Key features of the asset class

The term “investment grade credit” is used to describe corporate bonds that have been issued by high quality companies. The three main rating agencies use slightly different definitions. Moody’s defines investment grade securities as having a rating of Baa3 or higher. Meanwhile, Standard & Poor’s and Fitch define it as BBB- or higher.

Several key benefits can make investment grade corporate bonds attractive to investors:

Good income generators

Investment grade corporate bonds can play an important role as income generators in investor portfolios. This made them popular with investors in the years following the global financial crisis when the world lived through a sustained period of low yields, or even negative yields on government debt.

Historically, the higher coupon from corporate bonds relative to government bonds has helped offset the potential for negative performance. As shown in Figure 2, the yield of 5% on global corporate bonds is around 0.8 times the duration of the index at 6 years, which means you would need to see a further yield rise of 0.8% to experience a negative outcome. As before, this ratio stands at post-financial crisis highs.

Less volatile than equities

Despite paying a higher level of income than government bonds, investment grade corporate bonds do not typically expose investors to an excessive level of risk. They tend to exhibit significantly lower price volatility than equities, for example.

By way of example, let’s take a look at the Bloomberg US Corporate Index. Over its full lifespan, there have only been 11 calendar years with negative returns. Nearly 80% of the time, index returns have been positive with an annualised average return of 7.26%. If you compare this to US equities, you will see a higher annualised return of 10.89% over the same period, but greater volatility (13 down years).²

Low credit risk

History shows us that defaults are very rare for investment grade issuers. Even between 2008 and 2009, the default rate peaked at only 0.3-0.4% of the universe. The threat of credit downgrades is more common, but can be mitigated with thorough credit analysis.

Good diversifiers

Investment grade corporate bonds represent a large portion of the global investment universe. This means they can offer strong diversification benefits, allowing investors to gain exposure to a broad range of economic sectors and geographies.

Highly liquid

Investment grade corporate bonds are sold on a large secondary market and are typically more liquid than their high yield counterparts.
 

What are the risks with investment grade credit?

As with any investment, there are risks as well as benefits. For example, when the economy takes a downturn, the risk that companies will be unable to meet their financial obligations increases. As introduced previously, the risk of defaults has historically been very low for investment grade issuers, however ratings downgrades can pose a more meaningful risk.

In the period surrounding a downgrade, a bond’s price will usually fall as investors demand a higher risk premium or sell out of the security in question. This can result in mark-to-market losses. However, if the company does not ultimately default, these can be recouped as the coupon payments are made and the bond is ultimately redeemed at par.

Active credit research can help reduce the risk of defaults and downgrades. The aim is to identify excess return opportunities across a broad range of economic environments, while mitigating against downside risk. This means identifying companies that aren’t reliant on favourable economic conditions to service their debt, and that have strong asset coverage and ample free cash flow, among other factors.

Behaviour over a full market cycle

Figure 4 outlines the performance of fixed income assets across a typical market cycle, based on data covering the last fifty years. As you can see, investment grade credit has a role to play across a broad range of environments. That said, there are some key trends investors can look out for, which we explore in further detail below.

How does investment grade credit behave in periods of economic slowdown and recession?

American investor Bill Gross once referred to bond investors as “the vampires of the investment world”, claiming that they loved “decay, recession – anything that leads to low inflation and the protection of the real value of their loans”.

Indeed, as well as being associated with lower inflation, economic slowdowns tend to coincide with peak rates and central banks becoming less hawkish, which is good for fixed income assets in general. As we know, interest rates and bond prices are inversely related, so when interest rates rise, bonds fall in value. In other words, fixed income assets tend to rally during this later phase of the economic cycle, as interest rates start to stabilise.

Having now reflected on fixed income assets in general, let’s take a closer look at investment grade credit.

As you can see from the above chart, high quality fixed income assets (government bonds and investment grade credit) tend to outperform high yield credit at this phase in the cycle. This is partly because, when markets throw up challenges, many investors start reducing credit risk in their portfolios and flock to “safe haven” assets, which exhibit less price volatility. IG credit investors can benefit from these moves.

Did you know? 

Over the past six US recessions, corporate bonds were positive in five of them. 

How does investment grade credit behave in periods of economic recovery and expansion?

As the market enters the recovery phase of the economic cycle, credit spreads tighten considerably. Government bond returns are limited during these periods, as interest rates are typically low. For those who are still cautious in their approach, but keen to increase their exposure to credit risk, a switch from government bonds into investment grade credit could prove attractive, as tightening spreads can produce strong price performance.

Meanwhile, later on in the cycle, as the market shifts from a period of recovery to one of economic growth, investment grade credit doesn’t tend to perform so well. Although credit spreads generally continue to tighten during this phase (which leads to outperformance relative to government bonds), a more hawkish approach from central banks can create challenges. To prevent economic growth from becoming unsustainable, central banks typically start hiking rates at this point in the cycle. Yields rise accordingly, and this limits the potential for strong returns from fixed income in general. 

Incorporating ESG considerations

Over the last 10+ years, ESG has really gone from a “nice to have” to a “have to have” as far as many investors are concerned. Traditionally, it has been a little harder to implement in the fixed income than the equity space. But, in some respects, corporate bonds have been a good place to start. One reason for this is that equity shareholders have voting rights, and so company management teams are incentivised to drive positive ESG change. Bondholders however do have some influence, as most management teams appreciate that poor ESG practices can be punished with higher risk premiums (and therefore interest costs) on company debt.
 

What are the advantages for investors?

ESG investing allows clients to align their portfolios with their values, which is important. But, from a financial perspective, there can be benefits too. Beyond any ethical considerations, many credit events have their roots in some kind of ESG-based deficiency. As such, many investors incorporate ESG factors as part of the fundamental credit research process. 

How do ETFs hold up when it comes to ESG?

There’s a common misconception that ETFs can only go so far in terms of incorporating ESG. And, indeed, they began life by simply avoiding controversial industries and activities. However, since then, a wide range of strategies have evolved to fill the gap between simple exclusions and “best-in-class” approaches that seek out companies doing the “most good”.

For example, many of the engagements led by Invesco’s in-house ESG team pertain to our entire physically invested fund range. In other words, passive investors benefit from our active engagement processes. This is a good example of how Invesco’s global scale can bring advantages.