Anil Katarya, CFA
Global Head of Investment Grade Credit
Travis King, CFA
Head of U.S. Investment Grade Corporates
Hans Sapra
Client Portfolio Manager
With the rise in fixed income yields, high-quality markets such as U.S. IG corporate bonds may offer attractive income along with potential diversification benefits from low correlations to other risk assets and enhanced downside protection.
Highlights
- At $5.9 trillion, the U.S. investment grade (IG) corporate bond market is one of the largest and most liquid asset classes in the world, presenting relative value opportunities and inefficiencies that active portfolio managers can capture (Exhibit 2).
- With interest rates now notably higher, investors can once again target a higher income stream without sacrificing credit quality (Exhibit 3).
- IG corporates have historically been an effective diversification tool, with low correlations to equities, U.S. Treasuries and riskier fixed income segments (Exhibit 5).
- The asset class may also provide downside protection, having generally preserved capital during periods of crisis better than other risk assets — and even better than Treasuries (Exhibit 6).
Why U.S. investment grade credit?
In a diversified portfolio comprising stocks, bonds, cash and alternative investments, for most investors, the fixed income allocation can help protect capital in volatile periods and provide a reliable source of income over time.
During the prior decade of low interest rates, balancing principal protection with the need to generate sufficient yield and income posed a significant challenge to investors, unless they increased credit risk. With interest rates having risen materially, higher-rated, lowerrisk segments of fixed income such as U.S. IG corporates are now offering higher all-in yields, meaning investors have less need to sacrifice credit quality in pursuit of returns. In addition, U.S. IG corporates can offer attractive diversification benefits, thanks to their low correlations with equities and riskier segments of the fixed income market (such as high yield bonds and bank loans).
We see several reasons for investors to consider allocating to U.S. IG credit:
- Financial stability: To qualify as investment grade, an issuing company must receive a credit rating of between Aaa and Baa3 from Moody’s or AAA and BBB- from Standard & Poor’s. The relative financial stability of these companies has helped the U.S. IG corporate segment generate long-term positive returns through multiple credit cycles (Exhibit 1).
- Size and liquidity: U.S. IG corporate debt is one of the largest and most liquid markets in the world, having tripled in size since 2007 to stand at $5.9 trillion as of December 31, 2022 (Exhibit 2).1
- Relative value: The size and scope of the market may offer investors relative value opportunities and inefficiencies that may be captured via active portfolio management. We believe active management, driven by rigorous fundamental analysis and a keen awareness of how corporate management teams respond through various stages of the credit cycle, is key to exploiting these inefficiencies and generating consistent potential performance while protecting to the downside.
- Attractive pricing: U.S. IG corporate debt is arguably more attractively priced today than it has been for more than a decade, as all-in yields have risen sharply in line with interest rates (Exhibit 3). Higher-quality, lower-risk assets such as U.S. IG corporates may help investors meet their yield requirements without needing to take undue credit risk in lower-rated segments of fixed income.
As of 12/31/22. Source: Bloomberg Barclays. Investment grade bonds are represented by the Bloomberg U.S. Corporate Index. See back page for index definitions.
As of 02/28/23. Source: Bloomberg. Pan-Euro High Yield: Bloomberg Pan-European High Yield Index; EM Corporate: Bloomberg EM USD Corporate & Quasi-Sovereign Index; Pan-Euro Securitized: Bloomberg Pan-European Securitized Index; U.S. High Yield: Bloomberg U.S. High Yield Index; U.S. Govt Related: Bloomberg U.S. Government Related Index; EM Sovereign: Bloomberg USD EM Sovereign Index; Pan-Euro IG Corporate: Bloomberg Pan-European Corporate Index; U.S. IG Corporate: Bloomberg U.S. Corporate Index; EM Local Currency: Bloomberg EM Local Currency Government Index; U.S. Securitized: Bloomberg U.S. Securitized Index; Pan-Euro Treasury: Bloomberg Pan-European Treasury Index; U.S. Treasury: Bloomberg U.S. Treasury Index; Asia Pacific Treasury: Bloomberg Asia Pacific Treasury Index. See back page for index definitions.
As of 03/31/23. Source: Bloomberg Index Services Limited and Voya Investment Management. Treasuries represented by the Bloomberg U.S. Treasury Index. Yields by credit quality represented by the Bloomberg U.S. Corporate Aa, A and Baa subindices and the Bloomberg U.S. High Yield Corporate 2% Issuer Cap Ba and B subindices. Orange dashed line represents the U.S. Treasury Index yield and the blue dashed line represents the Bloomberg U.S. Corporate Baa Index yield as of 03/31/23. See back page for index definitions.
While the breadth of the market and the yields available can look compelling, U.S. IG corporates also possess three key features that may help investors mitigate downside risk.
1. U.S. IG corporate bonds have generally been a relatively safe asset class over time. Corporate defaults within U.S. IG credit have been infrequent and minimal over time compared with other credit-sensitive asset classes (Exhibit 4). However, it is important to consider idiosyncratic downgrade risk in the IG corporate market. Although downgrades of companies to below investment grade — so-called “fallen angels” — are rare, such downgrades are a key driver of spread volatility. Passive approaches to investing in the IG corporate market may expose investors to this unnecessary additional risk. By contrast, active managers aim to manage downgrade risk through credit selection, potentially avoiding downgrades that may occur.
2. A dedicated U.S. IG corporate sleeve can serve as an effective diversification tool. The asset class has historically demonstrated low correlation to both equities and U.S. Treasuries, as well as to riskier segments of the fixed income market, such as emerging market debt, high yield bonds and leveraged loans (Exhibit 5).
3. U.S. IG corporate bonds have historically delivered compelling downside protection during periods of significant market stress (Exhibit 6).
As of 12/31/22. Source: S&P Global Ratings Research and S&P Global Market Intelligence’s CreditPro®.
As of 03/31/23. Source: Bloomberg. Correlation of monthly total returns. U.S. investment grade: Bloomberg U.S. Corporate Index; U.S. Aggregate Index: Bloomberg U.S. Aggregate Index; U.S. Treasuries: Bloomberg U.S. Treasury Index; Agency residential MBS: Bloomberg U.S. Mortgage-Backed Securities Index; U.S. asset-backed Securities: Bloomberg U.S. Asset-Backed Securities Index; U.S. commercial MBS: Bloomberg U.S. CMBS Investment Grade Index; U.S. high yield: Bloomberg U.S. High Yield Index; U.S. senior loans: Morningstar LSTA Leveraged Loan Index; Emerging markets debt: JP Morgan EMBI Diversified Index; S&P 500: S&P 500 Index. See back page for index definitions.
As of 12/31/22. Source: Bloomberg and Voya Investment Management. * Periods covered correspond to chart above. Stress periods: 2000-2003, 2008, 2011, 2015, 2018, 2020. Recovery periods: 2003, 2009, 2012, 2016, 2019, 2021. U.S. investment grade corporate bonds: Bloomberg US Corporate Index; U.S. high yield bonds: Bloomberg US High Yield Index; U.S. bank loans: Morningstar LSTA Leveraged Loan Index; U.S. stocks: S&P 500 Index; U.S. Treasuries: Bloomberg US Treasury Index. See back page for index definitions.
Looking at market returns in crisis periods over the last 20-plus years, the U.S. IG corporate market outperformed senior bank loans and U.S. stocks during the dot-com crash, the 2008 financial crisis, the European sovereign debt crisis, the 2015 energy crisis, the U.S. Federal Reserve’s 2018 hiking cycle and the Covid pandemic. Even allowing for a rebound year following each crisis, total returns for the U.S. IG corporate market through all the combined crisis and rebound years exceeded those of the aforementioned markets.
U.S. IG corporates did underperform U.S. high-yield bonds in four of the five crisis-and-recovery periods, but the underperformance across all periods was a modest 7%. When accounting for the significantly lower volatility profile (a standard deviation of 1.74% vs. 2.70%), the underperformance versus high yield does not look too drastic.
Perhaps even more surprising is that, as Exhibit 6 shows, over the same periods of crisis and recovery, U.S. IG corporate bonds delivered better returns than U.S. Treasuries — which are considered a safe haven for capital conservation during volatile periods.
Is yield back in U.S. IG?
We believe that in the current market environment, U.S. investment grade corporate bonds may be an appealing asset class. Years of low interest rates may have tempted many investors into lowerrated parts of fixed income in pursuit of yield, but with rates having risen significantly, U.S. IG corporate debt is arguably more attractively priced today than it has been for over a decade. With the economic outlook still uncertain, we see the potential diversification and downside protection characteristics of the asset class as additional positives.
In our view, U.S. IG corporate bonds can provide strong long-term risk-adjusted returns and diversification to investors’ fixed income portfolios.