How have corporate bond returns fared when spreads are tight?
Navigating the corporate bond market in times of tight spreads can be tricky. We show that for long-term investors, keeping a strategic perspective potentially trumps more tactical views on the best entry point.
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Tight spread environments can be a challenge for the returns of corporate bonds compared to government bonds. However, slim spreads do not necessarily spell disaster for corporate bond investors.
This risk of underperformance comes through if you are trading corporate bonds. Corporate bond prices will fall if spreads increase to more normal levels, all else equal. However, is this the best measure for long-term investors? Default rates on investment grade (IG) corporate bonds have averaged 0.1% per year over the long run, meaning 99.9% have not defaulted in any given year. Although you’re not getting compensated as much for lending out your money, it is not to say that holding to maturity won’t yield returns exceeding those from government bonds. For many investors, this strategic outcome potentially trumps more tactical views on the best entry point.
Furthermore, current overall yield levels are significantly higher than they have been for much of the past decade. This provides a larger margin of safety against the risk of negative returns. On a 12-month view, IG yields would need to rise by around 0.7%, while yields on high-yield (HY) bonds would need to rise by around approximately 2% before bondholders would be left nursing losses.
Tight spreads are clearly not great for corporate bond prospects, but they don’t have to be awful either. It depends on your time horizon and perspective.
Despite recent market volatility, USD spreads are tight relative to history, with both IG and HY spreads being close to their post global financial crisis lows (Chart 1). Looking further back to when data began in 1997, they stand in the 19th and 11th percentile respectively, meaning they’ve only been lower 19% and 11% of the time.
Chart 1: USD spreads are tight relative to history…
Unsurprisingly, tight spreads have historically been challenging for returns of corporate bonds relative to government bonds…
For corporate bond investors, excess return is an often-used measure of performance and is defined as the total return of the corporate bond minus the total return of the underlying government bond. Our analysis shows a clear association between high spreads and stronger excess returns. Low spreads are associated with weaker excess returns, although there is more variability in outcomes at this end of the scale (Chart 2). Worse outcomes at lower spreads makes intuitive sense given a lower spread ‘carry’ (the extra interest earnt over the relevant government bond) and less room for significant further spread compression (whereby the bond price increases). All else equal, excess returns will be higher the starting spread and the more spreads tighten over the investment period.
Using over 27 years of monthly data, we compare starting spread levels to the 3-year forward annualised excess returns. The analysis uses rolling periods to ensure sufficient data points (compared to the alternative approach of non-overlapping periods), but this means the very poor returns during the tech bubble burst and global financial crisis (GFC - green dots) play an outsized role as they feature in multiple periods/data points. However, the general finding that tighter spreads have historically given lower excess returns remains valid.
Chart 2: USD IG and HY excess returns have been weaker when spreads are tight…
Past performance is not a guide to future performance and may not be repeated. The above chart shows annualised excess returns 3-years ahead for each starting spread. Similar conclusions at other horizons of 1-year and 5-years. Based on monthly data to December 1996 to June 2024. The analysis uses rolling periods to ensure sufficient data points. Green dots show GFC period of 2008-2009.
And with low spreads, the odds of corporate bonds underperforming government bonds over the following one to three years are elevated…
We have split spreads into decile buckets (meaning spreads have spent 10% of time in each bucket) to measure how wide or tight they are, and then looked at ‘hit rate’ analysis, which is defined as proportion of time where subsequent excess returns are positive. Hit rates tend to be lower when spreads start from tighter levels and are weaker in IG than HY. For example, when IG spreads have been in the 1st decile, positive 12-month excess returns have been generated only 12% of the time (Chart 3 – left panel). But in HY it has been much higher at 41% (Chart 3 – right panel).
The odds of outperforming government bonds improves markedly when in the 2nd decile. And the likelihood of generating excess returns has been highest at very elevated spreads levels.
Chart 3: Hit rates have been much lower in IG than HY when spreads are tight…
Past performance is not a guide to future performance and may not be repeated. Chart shows ‘hit rates’ at various forward time horizons, with starting spread levels split into decile buckets. ‘Hit rate’ defined as proportion of time where subsequent excess returns are positive. Analysis based on monthly data to December 1996 to June 2024. The analysis uses rolling (overlapping) periods to ensure sufficient data points.
Tight spreads are clearly not great for corporate bond prospects, but they don’t have to be awful either. It depends on your time horizon and perspective.
This risk of underperformance comes through if you are trading corporate bonds. Corporate bond prices will fall if spreads increase to more normal levels, all else equal. But is that the right metric for long-term investors? Default rates on investment grade corporate bonds have averaged 0.1% per year over the long-run, meaning 99.9% have not defaulted in any given year (Chart 4). Even within HY where default rates can spike much higher, the long term average annual default rate has been around 4% in the last four decades (2.9% since 1920). And even if there is a default, everything is not lost as recovery rates on defaulted bonds have averaged around 40% over the long term.
So while you’re not getting compensated as much for lending out your money that is not the same as saying you won’t get a return above government bonds if you hold to maturity. For many investors that strategic outcome may trump more tactical views on the best entry point.
Chart 4: Corporate defaults have been extremely rare in investment grade…
Furthermore, overall yield levels are at much more reasonable levels compared to the past decade. This provides more of a margin of safety against the risk of outright negative returns…
With inflation having fallen back towards target levels and central bank policy rates expected to decline, long term investors may view corporate bonds as attractive to lock-in elevated yields for longer.
And even for those investors that don’t hold bonds until maturity, higher yields have brought about a greater ‘margin of safety’. On a 12-month view, IG yields would need to rise by around 0.7% and HY yields around 2% before bondholders would be left nursing losses. (Chart 5). While this doesn’t eliminate risk, this elevated buffer should provide some reassurance to long-term investors worried about the risk of further price declines.
Chart 5: Higher yields have brought a bigger margin of safety against further interest rate rises…
The ‘margin of safety’ is how much of a rise in yields they can absorb over the next 12 months before investors would lose money. This assumes a one-year holding period. Chart show local currency yield to maturity divided by modified duration.
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