By the research team at Invesco Asset Management.

Is now a good time to buy investment-grade credit?

The choice between credit and duration risk is increasingly important especially in today’s low/negative yield environment.

With 10-year Treasury yields converging towards the shorter end, investors are not being compensated sufficiently for taking on duration risk.

In our view, investment-grade corporate bonds offer enough pick up in yield over government bonds to make credit risk arguably more appealing.

More than 25% of the global debt market has a negative yield

Globally, fixed income yields remain close to historic lows, which makes your bond allocation more important than ever. As can be seen in the chart below, the value of all the debt with a negative yield remains close to an all-time high at nearly $15 trillion. That equates to a little over a quarter of the global aggregate bond index.

Value of global debt with a negative yield

Source: Invesco.

The concern, however, is not just the amount of negative-yielding debt, but also the duration of that debt. The first negative-yielding bonds tended to be those close to maturity, so the average duration of negative-yielding debt was low. But as central banks have introduced negative base rate policies, the yields on longer-dated bonds have been driven into negative territory. Consequently, the average duration of negative-yielding debt is now 5.7 years or almost 80% of the global aggregate bond index duration.

Duration of negative-yielding debt has also increased

Source: Invesco.

The low (and/or negative) yield environment has driven investors to take on either more interest rate (duration) risk or more credit risk to achieve their yield and return targets. So, the question is which of these risks is better to take on.

Interest rate (duration) risk

When yield curves are steep – e.g. when the 10-year yield is significantly higher than the 2-year yield or base rates – investors are being compensated for taking on the additional interest rate risk with some additional yield. However, when yield curves are flat, and the 10-year yield offers little or no additional yield, investors are not being compensated for taking on that additional risk. The actual level of additional (or potential loss of) yield for increasing duration will depend on many factors, including the macroeconomic outlook.

Currently, government bond yield curves (as measured by the difference between the 2- and 10-year yield) are at the lowest levels post-financial crisis.

Spread between 2-year and 10-year government bond yields

Source: Invesco.

What is unusual this time when compared with previous cycles is that 10-year yields have fallen to converge on the 2-year yield in the major markets.  Normally, we would expect to see movement at the other end, with yield curves flattening as central banks tighten monetary policy, driving the 2-year yield higher so that it converges on the 10-year yield. So, right now adding duration risk does not appear particularly attractive.

Credit risk

With interest rate risk not looking particularly attractive, what about credit risk?  Looking at US dollar-denominated investment-grade credit spreads, we see the pick-up in yield over US Treasuries is just below the long-term average.  The chart below shows the additional yield on the Bloomberg Barclays US Corporate Total Return Index versus the Bloomberg Barclays US Treasury Total Return Index over the last 45 years.  Recessionary periods are shown in grey.

Investment-grade spread just below long-term average

Source: Invesco.

As can be seen, spreads tend to widen ahead of and during a recession but tighten and stabilize during expansions. With spreads only just below the long-term average and, while growth is subdued, a recession not appearing imminent, there appears to be a lack of catalyst to drive spreads wider in the near term. Indeed, the recent rate cuts by the Fed and easing on policy from the European Central Bank appear to be pre-emptive to reduce the prospects of a recession, which should be supportive for credit markets.

Looking at the spread in isolation, however, may miss the real opportunity within investment-grade credit. In the current low yield world, it may be better to look at the additional yield offered by credit markets over government bonds as a percentage of total yield. In the chart below, the dark blue line shows this additional yield and the green line shows the Bloomberg Barclays US Treasury Total Return yield.

Yield pick-up as a percentage of overall yield

Source: Invesco.

What you can see here is that, when US Treasury yields were high, the credit spread as a percentage of total yield was low. But as US Treasury yields are low (1.72%), the yield pick-up of 1.19% is over 40% of the total yield. For Europe, the story is even more compelling as the yield on a broad eurozone government bond index is negative while the yield on the corporate bond index is 0.40%, i.e. the additional yield expressed as a percentage would be over 100%.

Conclusion

Government bond yields are at historically low levels and yield curves are flat, meaning there is little additional yield on offer for taking on more interest rate risk. However, investment-grade credit spreads are only slightly below historic averages and, when looking at the additional yield offered by credit over that for government bonds as a percentage of total yield, it is at its highest level except for the financial crisis and its aftermath.

Unless you are anticipating a significant economic downturn, the current yields in the market would appear to favour taking on investment-grade credit risk rather than duration risk.

(The views expressed here are those of the authors and do not necessarily reflect those of ETF Strategy.)