Investment grade bonds: past their prime?

As yields trended lower over the last decade, investment grade bonds have offered investors reasonable yield of approximately 3%, relatively low risk of principal loss, and attractive total returns of just over 5% annualized. Today, despite a favorable growth backdrop and expectations for low defaults, we believe the risk-adjusted reward in investment grade is increasingly unattractive.

The all-in yield on any corporate bond has two components: rates and an additional spread to compensate for risks such as credit risk and lower liquidity. Today, both components are at historically low levels, resulting in an all-in yield of just 2% for the Bloomberg Barclays US Corporate Index. With U.S. inflation north of 2% today and return expectations on investment grade credit of 1.2% over the next 5 years (according to the BlackRock Investment Institute), even a small increase in interest rates could wipe out a year’s worth of return.

When making historical comparisons, it’s important to consider how things have evolved compared to past periods. With respect to investment grade, the story isn’t a good one. Over the last 15 years, we have seen the maturity profile of the investment grade sector lengthen, which has led to greater interest rate risk. This means that investment grade bonds are even more sensitive to changes in interest rates than they have been historically.

Similarly, when evaluating credit risk, it’s worth noting that the proportion of the market made of up BBB (or the lowest rated investment grade companies) has grown as a percentage of the asset class. Thus, for a spread compensation today that is like prior cyclical tights, investors are actually owning a lower quality asset.

Investment grade bond universe has trended towards longer maturities...

...and lower credit quality

After accounting for these more structural asset class changes and the ultra-tight spread backdrop, we increasingly view investment grade bonds as an asymmetric opportunity with more downside than upside. In our portfolios, we’ve used the rally over the past year as an opportunity to reduce exposure in favor of assets that offer a more attractive range of outcomes and higher expected returns. We continue to like the risk/reward in floating rate loans and dividend paying equities (which offer some distribution growth to boot!)