When compared with historical values and, in particular, with the periods following the financial crisis and the Covid-19 pandemic, the “all-in” returns of the investment grade segment are currently high. This is what emerges from the analysis by Alasdair Ross, head of investment grade EMEA at Columbia Threadneedle Investments.
As is known, the return generated by investment grade securities can be broken down into two main components: on the one hand, the return of the underlying government bonds and, on the other, the credit spread, which represents the extra return associated with the risk of corporate credit. In this context, it is the yield on government bonds that is particularly high, while the credit spread appears relatively limited. Regarding spreads, a note of caution should be expressed. Although company fundamentals are very solid, valuations appear to incorporate near perfection, considering the current level of spreads. Therefore, if earnings or the macroeconomic environment disappoints, we could see a slight widening of spreads.
“At the moment – underlines Ross – we believe it is advisable not to overload credit allocations; Current credit spreads reflect the strong fundamentals of issuing companies. However, since we have no protection mechanism in the event of adverse events, it is prudent to exercise caution and avoid taking excessive credit risks in portfolios.”
Duration in a world of lower rates
Recent decisions by central banks to reduce interest rates have made duration a more attractive option for investors. If these cuts continue, we could see a steepening of yield curves in 2025. In the short term, yields are expected to decline in response to central banks’ monetary easing programs. However, for maturities of ten years and beyond, a decline in yields is not observed, as markets express concerns about fiscal deficits and incorporate a risk premium. Despite these concerns, the environment remains favorable for duration. Over the past two years, investors have enjoyed attractive returns from cash. As rates fall, it may be advantageous to move towards longer maturities and take on slightly more duration risk to take advantage of the returns offered by the long-term segment. This strategy could prove profitable in the current context of reducing interest rates and stabilizing inflation.
What prospects for spreads?
“We do not foresee – states the Columbia Threadneedle Investments analyst – a potential substantial increase in credit spreads, at least in the short term, and the main reason is that corporate fundamentals are currently extremely solid. Corporate leverage is at decade lows in both the United States and Europe, while globally, bank capital has reached historic highs. Furthermore, asset quality should remain at low levels. However, a possible recession, accompanied by a sharp decline in corporate profits, could trigger a widening of spreads. In a recession, we would expect investment grade spreads to hover between 170 and 190 basis points rather than remain below 100 basis points relative to government bonds, as is currently the case. Despite this possibility, we do not foresee a recessionary scenario. Even if a recession were to materialize, companies currently have considerable flexibility in deciding how to navigate such an environment. This means that, even in the event of economic difficulties, companies could adapt and better manage their financial resources and strategies to face any future challenges.”
A favorable context for investors
Currently, the overall return on investment grade bonds looks attractive, with an overall IG rate of return of 4.5% and a long-term IG rate of return of 5.5% to 5.9%. This type of return is particularly attractive when compared to the long-term return of stock markets, which is between 7% and 8%. “Therefore,” Ross continues, “if we could get a 5% return from investment grade bonds, which occupy the upper end of the capital structure and are significantly less volatile than equity markets, that would be highly competitive. While in the short term we are slightly cautious about taking on spread risk given the very low levels we are starting from, over the long term and over a longer holding period, we believe investors can get that additional spread, represented by an extra -yield compared to government bonds. The excess return offered by an asset class with very strong fundamentals, combined with overall returns historically similar to those of equities, creates a rather favorable environment for investors who can continue to hold credit and invest in this asset class, benefiting from opportunities interesting in the bond market.”
“Overall,” concludes the head of investment grade EMEA at Columbia Threadneedle Investments, “our outlook for investment grade corporate bonds remains positive, especially in a slowing economic context and with expectations of future interest rate cuts by banks central. This scenario, in fact, could further support returns and improve the performance of investments in this segment.”
