Is Now The Time To Look At Corporate Bonds To Boost Returns?

Is Now The Time To Look At Corporate Bonds To Boost Returns?

Investors are using corporate bonds to boost prospective returns within their fixed income portfolios with government bond yields at record lows, which is creating a ‘tailwind’ for the asset class according to First Sentier Investors.

The Global Credit Outlook 2021 paper argues prevailing economic conditions should underpin credit demand going forward.

Craig Morabito, Senior Portfolio Manager in First Sentier’s Global Credit team, said as government bond yields remained low, income-focused investors were “looking up the risk spectrum”.

“The traditional barbell approach of higher-risk equities and lower-risk government bonds doesn’t replicate the risk/return characteristics of global credit markets,” he said.

“Adding corporate bonds to a portfolio can therefore provide additional income without adding significant risk.

“In today’s market, companies want to issue bonds and investors want to buy them. Global corporate bond markets enjoyed nearly A$300 billion of inflows in 2020.

“That’s a record level of demand, and companies tapped into it by issuing record volumes of new bonds to bolster their balance sheets.

“New bond issues in the second half of 2020 were typically several times over-subscribed, underlining investors’ appetite for income-producing investments and providing a strong tailwind for credit,” Mr Morabito said.

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While the Global Credit Outlook 2021 report acknowledges current returns are subdued, it says they should be considered alongside other defensive assets.

“The current prospective income of around 2.3% pa from investment grade credit may not get investors’ pulses racing, but government bonds are yielding less than half that in most markets.

“Additionally, we believe there is room for valuations to improve, even beyond the strong rally already seen in the asset class. Credit valuations are more attractive in some areas of the market than others, so there is scope for active managers to allocate strategically to regions and sectors that are most attractive from a risk/return perspective,” Mr Morabito said

While corporate credit has a higher risk rating than government bonds, the Global Credit Outlook 2021 looked at how these risks can be managed.

Looking at default risk, analysis by Moody’s Investors Services shows there were no defaults at all among investment grade corporate issuers in nine of the past 20 years. And in the period as a whole, the average default rate was 0.23% pa on a volume-weighted basis. Moreover, investors can typically claw back some capital following an issuer default, with investors recovering, on average, 45 cents in the dollar.

“The term ‘default’ can create concern for investors, as nobody likes the idea of losing money. However, the actual frequency and magnitude of defaults is far less than people might expect, especially for investment-grade bonds.

“Moreover, quality active management, based on robust credit analysis, can reduce the default rates even further. While default risk is present in credit investments, it can be managed effectively,” Mr Morabito said.

Volatility is another risk often cited for credit investments. However, the paper points out that while returns fluctuate over the cycle, credit markets have always rebounded from temporary drawdowns.

“Following underperformance during the GFC in 2008, positive excess returns exceeded 17% in 2009. Even in 2020, excess returns were positive, as credit bounced back very strongly from the sell-off last February and March.

“These typically swift upturns have rewarded investors who persevered with the asset class during periods of uncertainty, and helped credit markets generate returns over full market cycles. Patience is rewarded in this asset class,” Mr Morabito said.