Corporate bond yields began climbing rapidly at the start of 2022, creating difficulty for many market participants. However, the rise in yields sets the stage for bond investors to reap higher levels of income than previously available.
This is because the average European investment grade corporate yield is around 3.9%, as measured by the Bloomberg Pan-European Corporate Bond Index. Meanwhile, high-yield corporate bonds yield around 7.7%, as measured by the Bloomberg Pan-European High Yield Index. This compares to a dividend yield for the MSCI World Index of around 1.8%.
Critically, many corporate issuers have funding costs well below current market yields, so have been insulated from the rise in rates. That’s because 63% of investment-grade corporate bonds and 69% of high-yield bonds were issued before 2022.
While a bond investor should care about yield and not typically make issuance year a focus, this dynamic provides some cushion to bond investors as corporate funding costs are only rising slowly as bonds mature and need to be refinanced.
This sets up a win-win for bond investors and the companies in which they invest: a win for the investor because they can harvest today’s higher yields from high-quality companies, and a win for many corporations as they can comfortably service their debts at pre-2022 coupon levels.
With rate cuts nearly upon us, the rates environment should become friendlier for corporate refinancing in the years ahead.
Exploiting market inefficiencies
Given where we are in the economic cycle, plus the political landscape, we expect volatility to increase, which should create plenty of market dislocations to exploit.
The rise of passive investing in the past decade has dramatically reduced the cost of investing in bonds, but it has also created significant inefficiencies for active bond investors to exploit, as comparatively less active money has been available to arbitrage away relative or absolute value opportunities.
A key risk for passive bond investing is that fixed income benchmarks are fundamentally flawed in a way that equity indices are not. Unlike equity indices, bond indices tend to apply weightings based on debt outstanding. This can mean passive bond investors are unintentionally overweight and overexposed to more heavily indebted companies.
An active investor can generally seek to avoid this scenario, particularly in an environment where growth may be challenged, calling into question the creditworthiness of the most indebted borrowers.
Who stands to benefit?
We believe an active approach to bond investing allows investors to take more intentional tilts in favour of bonds backed by companies with strong credit characteristics and those at an attractive valuation, among other risk factor tilts.
A savvy bond investor can exploit the many inefficiencies that arise from large index-tracking strategies that are focused on closely tracking a benchmark, rather than risk-adjusted return generation.
Consider, for example, actively managed multi-sector fixed-income strategies that offer yield and some shelter from volatility. Additionally, a strategy focused on a single sector such as high-yield bonds can offer equity-like returns with a lower risk profile than stocks.
Targeting inefficiencies effectively means casting a wide net across the fixed income universe, including corporates, governments, municipals, mortgage-backed securities, global bonds, emerging markets, and structured credit, and combining the best opportunities with precise risk scaling.
As economic growth is expected to slow, managers also need robust credit analysis capabilities, not just across corporate bonds but all forms of bonds, which requires extensive resourcing commitments.
Market inefficiencies are often durable but not large. Most notably, the risk premium available on individual bonds can be inefficiently priced, allowing credit-focused managers to target multiple security selection opportunities.
Unfortunately, some strategies might be just too large to implement a meaningful security selection position based on the volume of bonds outstanding. As a result, we find the largest bond funds are often overly reliant on duration positioning, which can be very volatile.
We believe managers need to be resourceful enough to find inefficiencies across the whole fixed income universe, such as employing credit analysts across the globe to cover issuers in their local market.
However, they also need to be nimble to have any hope of exploiting them, for example, by managing strategies small enough to take a security or sector selection position that can have a meaningful impact on performance.
Bonds might lack the glamour and buzz of many of the investment trends of the past decade, but they have the income, return, risk profile and staying power many are seeking. Welcome to the new golden age of bond investing.
Peter Bentley is co-manager of the BNY Mellon Global Credit fund and deputy CIO of fixed income at Insight Investment. The views expressed above should not be taken as investment advice.