Stuart Chilvers, fixed income fund manager, Rathbone Unit Trust Management, looks at whether this year, investment grade bonds will provide value for income-seeking portfolios.
Investment Grade corporate bonds (i.e. bonds with higher credit quality and hence a low probability of default) have long been a fundamental building block in portfolios looking to generate a healthy level of income. This is inherently logical, as they provide fixed (generally), regular income that allows the investor to forecast their income generation accurately.
However, over the past decade (up to the beginning of 2022) we had seen the yield to maturity on investment grade corporate bonds trend lower, which resulted in lower income yields from these bonds as well (as existing bonds with higher coupons matured, companies were able to issue new bonds with lower coupons to replace them given the lower yield to maturity required by investors).
At the extreme, this saw some investors querying the value of investment grade bonds within a portfolio, with some equity indices having dividend yields in excess of the income yield from Sterling corporate bond indices at times.
However, 2022 saw all of that change.
Last year we saw yields rise meaningfully as government bond yields increased significantly when it became clear inflation was proving far stickier than had been widely expected.
In addition, we saw credit spreads (the additional return investors receive relative to government bonds for taking on the default risk of the corporate issuer) widen significantly as expectations for the economic outlook deteriorated (in no small part due to the significant tightening of monetary policy we have seen as a result of the elevated inflation we have experienced).
The net result of these two moves means that, when we look at Sterling investment grade corporate bonds, yields recently reached their highest level in over a decade. We have seen a slight retracement recently, but the yield to maturity on a UK corporate bond index is still at levels we have not seen in the past decade bar the past few months.
This means that when look at forward returns on a 12 month basis, investment grade corporate bonds can offer a positive return, unless we see yields rise significantly further from here.
This will also see income yields rise – as yields rise, prices fall so mechanically the income yield from a bond increases. In addition, new issues are coming with far higher coupons (for instance we saw large, frequent issuers come to market with bonds in 2022 that had coupons north of 7%) which will also increase income yields at an index/portfolio level.
Earnings downgrades
Given the tough economic backdrop we are anticipating a period of earnings downgrades. We don’t think investment grade bonds will be immune to these earnings downgrades, but when we look at credit spreads on Sterling investment grade credit compared to their historic levels, it is clear some economic weakness is already being discounted.
And investment grade debt issuers by nature are already starting from a stronger position and are thus more likely to be able to endure a period of economic weakness without debt affordability becoming a significant issue.
It is also worth remembering something investors were reminded of during the Covid crisis – income from bonds is contractual (it can only not be paid if a company defaults generally), dividends are discretionary – meaning in a challenging economic climate, they may not deliver the income that had been expected.
Looking back, investment grade corporate bonds have historically performed well at the end of interest-rate tightening cycles. We don’t think we are there yet, but we clearly saw a very significant number of interest-rate increases in 2022 and our analysis suggests that we are likely to reach the end of the cycle at some point in the first half of this year.
While it is certainly possible that yields could continue to move higher, at current yields we believe you are being attractively compensated for that risk. With this increase in yields (both yield to maturity and income yield), we don’t expect to see many questioning the value of investment grade bonds within an income-seeking portfolio in the near future.
