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A more constructive outlook for corporate bonds, but caution is still warranted
Flavio Carpenzano
Peter Becker
July 5, 2022
It has been a difficult start to the year for investment grade corporate bonds, which returned -16.1% year to date1. As inflation jumped to the highest levels seen in decades in developed markets, major central banks have turned increasingly aggressive in their attempts to control it, gradually removing stimulus measures and raising interest rates. This has caused interest rate sensitive bonds, such as investment grade corporates, to sell-off. The Russia-Ukraine conflict has also contributed to an overall very volatile macroeconomic environment. As a result of the drastic revaluation, though, there is now arguably a much more attractive entry point for investors in investment grade corporate bonds.
More attractive valuations could present a good entry point for investors
Global investment grade spreads and yields
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Data as at 15 June 2022. Index used is the Bloomberg Global Aggregate Corporate Bond Index. The yield-to-worst is the lowest possible return over a particular period of time that can be received on a bond that fully operates within the terms of its contract without defaulting. The option-adjusted spread is the spread that accounts for the embedded optionality of some bonds. Source: Bloomberg
Companies also generally remain in good shape from a fundamental point of view. They continue to display healthy revenues and profit margins despite a higher inflationary and slowing growth environment.
Yields have reached levels not seen in more than 10 years although this was mostly driven by the rise in interest rates rather than spreads, which represent the perceived credit riskiness of bonds. At these higher yields investors now have the potential to earn more income from bonds in the future. Higher income can also offer more cushion for total returns over time, even if price movements remain volatile.
In addition, over a longer time frame the yield of a bond has turned out to be a good approximation of the total return that could be achieved. Therefore, at these levels, history would suggest potentially higher total returns over the next few years. The following chart shows the average 2-year and 5-year forward return (percent per annum) that has been achieved corresponding to the starting yield as at 15 June 2022. The total return on a bond is the function of price changes and interest paid — and the higher the starting yield of a bond the more it is cushioned from rising interest rates. However, the ride along the way could turn out to be a little bumpy.
Higher starting yields have boosted returns in the past
Average forward returns (% p.a.) at recent yield levels
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Yields as at 15 June 2022. Returns as at 31 May 2022 in US dollar terms. Data goes back to 2000 for all sectors except for emerging markets, which goes back to 2003. Based on average monthly returns for each sector when in a +/- 0.30% range of yield to worst. Indices used (left to right) are Bloomberg Global Aggregate Corporate Index, Bloomberg Global High Yield Index, and 50% JPMorgan EMBI Global Diversified Index / 50% JPMorgan GBI-EM Global Diversified Index blend. High yield: lower quality bonds rated BB or below. Sources: Capital Group, Bloomberg, JPMorgan
The current macroeconomic environment, however, remains highly volatile and an overall cautious and slightly defensive stance is still warranted. Careful selection in companies and sectors remains key.
1. As at 15 June 2022 in USD terms. Index used is the Bloomberg Global Aggregate Corporate Index. Investment grade: higher quality bonds rated BBB or above. Sources: Barclays, Bloomberg
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