A Changed Landscape for US Investment-Grade Corporate Bonds | Lord Abbett
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Fixed-Income Insights

Spreads on US investment-grade corporates have returned to pre-pandemic levels. How might investors approach the asset class in the current environment?

Read time: 3 minutes

  • In 2021, investment-grade corporate bonds endured their worst opening quarter in 30 years, as the impact of rising interest rates on the value of corporate bonds significantly outweighed any income and spread tightening that occurred over the quarter.
  • Normally, such an outcome would lead investors to review their allocation to the asset class.  Indeed, with the normalization of the United States underway and with it, commensurate expectations for strong economic growth, concerns over the impact of inflation remain a risk.
  • Despite this, the attraction of rotating into cash remains limited as risk-free yields provided by US T-bills remain at historic lows.
  • In this environment, we believe investors should embrace a flexible approach to high-quality fixed income and consider strategies that mitigate the impact of higher interest rates, which could rise further as the U.S. economy enters a period of robust, above-trend growth.

Following the extremely strong returns investors in investment-grade (IG) corporate bonds enjoyed over the last three quarters of 2020, the first quarter of 2021 provided a cause for pause.  The historic interventions undertaken last year by the US Federal Reserve (“Fed”) to underpin the orderly functioning of the financial markets in response to COVID-19, including rapid and meaningful rate cuts and the unprecedented purchase programmes for investment grade (and to a limited extend below investment grade) corporate securities stabilized sentiment.  As a result, spreads of investment-grade corporate bonds reverted from levels often associated with high yield in March 2020 to those found pre-crisis levels by early January 2021 (Figure 1).

 

Figure 1. Spreads on Investment-Grade US Corporate Bonds Have Returned to Pre-Crisis Levels
Option adjusted spread on the ICE BofA Corporate Index, 1 January 2019–31 March 2021

Source: Bloomberg. Data as of 31 Mar 2021. The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option.
Past performance is not a reliable indicator or guarantee of future results.  For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

In recent months,  landmark fiscal stimulus via the US$1.9 trillion COVID Relief package, encouraging economic indicators and a robust rollout of vaccinations in the United States led to a significant sell-off in longer dated US Treasuries, causing duration-sensitive US IG corporate bonds to endure their worst start to the year in three decades. Indeed, US investment-grade corporates (as represented by the ICE BofA US Corporate Bond Index) returned -4.5% in Q1 – the positive impact of modest spread tightening over the quarter and income were overwhelmed by negative price returns due to the impact of rising rates on duration.

With this backdrop, how should investors in high grade debt with a focus on income evaluate the opportunity set? We believe income-oriented investors in the asset class are likely to stay the course in the near term.  Broad macroeconomic conditions remain favourable - overall consumer confidence continues to improve1 as has the economic outlook from the perspective of US corporate boardrooms.2 Indeed, current forecasts for US GDP for 2021 are expected to normalize above trend levels in the second half of this year (Figure 2).

 

Figure 2. For 2021, a Vaccine-Led Normalization of US Economic Activity Is Expected

Sources: Trading Economics, BEA (U.S. Bureau of Economic Analysis), and Credit Suisse U.S. Equity Strategy Navigator, 1/4/2021. YoY = year-over-year. The historical data shown in the chart above is for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Perhaps more important is that unlike in previous periods, the alternatives for safe income are meagre (Figure 3).  While US investment-grade corporates provided yields of just over 2.25% as at the end of March 2021, that is 40x the yield provided by 12-month US T-Bills.  For those investors targeting shorter maturities, 1-3 year US corporates provide yields over 10x the level of those same T-bills.  And although income should not be the sole determinant for asset allocation, in an environment where spreads are tight and expected to remain rangebound, carry should be considered an important component of return.

 

Figure 3. Yields on US Corporate Bonds Far Outstrip Those of 12-Month T-Bills
Yields and yield ratios for the indicated asset classes, 1 January 2014–31 March 2021

Source: Bloomberg. Data as of 31 Mar 2021.  IG=Investment grade US corporate bonds. 1-3Y IG= 1-3 Year Investment grade US corporate bonds. UST=US Treasury bills. LHS=left-hand side. RHS=right-hand side.
Past performance is not a reliable indicator or guarantee of future results.  For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Further, if you consider the default risk associated with investment grade corporates, we believe investors are more than well compensated for the risk as spreads remain significantly wider than what would be justified by default risk. Along these lines, Bank of America recently highlighted that the average historical loss for investment grade bonds due to defaults were about 12 basis points per annum over the 30-year period ending 2019.3

As markets have moved from crisis management mode in 2020 to normalization today, how might investors mitigate downside risk and take advantage of an evolving landscape in corporate credit?  For those focused on the broad investment grade asset class itself, we suggest an active approach with emphasis on identifying relative value across credit rating and industry. We think this calls for a sensible approach to duration in an environment that is likely to continue to experience upward pressure on inflation and yields on longer-dated government bonds.  

Even more effective, in our view, would be a multi-sector approach to access opportunities in adjacent fixed income asset classes to provide a wider opportunity to identify attractive relative value as well as to complement the overall return profile and enhance the risk/reward characteristics of IG corporate fixed income allocations.   And because the excess return available in high quality short term credit is largely compensation for liquidity risk rather than principal risk due to default, a multi-sector approach with a focus on true short duration assets can potentially provide enhanced yields without sacrificing overall portfolio credit quality or liquidity.

 

1Source: Bloomberg; as measured by the University of Michigan Consumer Sentiment Index as at 31 March 2021.
2Source: Bloomberg, as measured by the US Business Roundtable CEO Survey Economic Outlook Index, as at 31 March 2021.
3BofA Global Research, Situation Room, 25 March 2021.

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

The credit quality of the debt securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from `AAA' (highest) to `D' (lowest). Bonds rated `BBB' or above are considered investment grade. Credit ratings `BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

Treasury Bill (T-Bill) is a short-term U.S. government debt obligation backed by the U.S. Treasury Department with a maturity of one year or less.

One basis point equals one one-hundredth of a percentage point.

Carry represents the additional return accruing to an investor from holding a higher yielding security over a lower yielding security, assuming prices remain constant.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

Securitized products (also known as structured products) are pools of financial assets that are brought together to create a new security, which is then divided and sold to investors. 

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark-bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point).

The ICE BofA U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market. The ICE BofA 1-3 Year U.S. Corporate Index is a maturity-specific subset of the index.

ICE BofA Index Information:

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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