09 Apr 2024
Rising rates have led to attractive yields across the fixed income market. However, corporate credit spreads are tight. This leaves many investors grappling with the valuations conundrum, as they debate yields versus spreads to determine their fixed income allocations. Will slowing economic conditions result in spread widening? Do higher yields provide a sufficient cushion against downside risk? And is now the time to add fixed income exposure?
In our view, it’s not too late for fixed income investors to take advantage of elevated yields.
Corporate bond spreads have narrowed to lows not seen since 2022. As the cycle extends and economy slows, it is no wonder investors are starting to worry about potential spread widening given the upside for capital returns is now more limited.
However, the attractiveness of asset classes can be evaluated using various metrics including yields, spreads, expected returns, etc. Many fixed income assets offer higher yields than has been normal in the last decade. Fixed income also offers enhanced income as coupon rates have reset higher. While spread levels look less compelling, all-in yields and higher coupons remain attractive.
Exhibit 1: Current yields are still well above 10 year medians
Source: Bloomberg as at 29 March 2023.
Although spreads are tight, investors mustn’t lose sight of the bigger picture. Over the long term, the starting yield has been a steady indicator of future long-term total returns.
As shown below, the starting yield-to-worst for the high yield index has been close to the subsequent annualised five-year return. This relationship has generally held true in strong and weak economic environments, as well as periods with tight and wide spreads, With high yield corporate bonds offering a starting yield to worst around 7.7%, we continue to like the asset class on a yield basis.
Exhibit 2: Starting yields have been a reasonable estimate 5-year returns
ICE BofA Global High Yield Index monthly YTW and forward 5-year index returns
Source: Aegon Asset Management, Bloomberg as at 31 December 2023. Based on the ICE BofA Global High Yield Index. Past performance is not a guide to future performance.
Even if spreads or yields widen from here, the breakeven rate for bonds is now considerably more attractive. The breakeven rate measures how high yields (or spreads) would need to rise before the total return of a bond becomes negative, typically over a one year time horizon. The total return of a bond has two components: price return and income return from coupon payments.
Prior to 2022, there was little income or yield available from newly issued bonds as markets had a prolonged period of low interest rates. However, as rates have shifted higher, yields across fixed income have risen and newly issued debt now offers higher coupon rates. Therefore, bond prices can now fall by a much greater degree before the total return becomes negative. For example, the yield on the US High Yield Bond Index can rise from the current level of 7.9% to over 10% - through wider spreads and/or higher core yields - before total returns break even. For US investment grade, yields can widen by 100 bps before investors lose money. This cushion is the biggest it has been for over a decade.
Exhibit 3: Enhanced breakeven profile for corporate bonds
Source: Aegon AM, Bloomberg as at 29 February, 2024. Based on monthly yield to worst data for the Bloomberg US Corporate and Bloomberg US Corporate High Yield index. Past performance is not a guide to future performance.
While there are attractive opportunities for fixed income investors to take advantage of current yields, we are cognisant that risks remain. While not our base case, reacceleration in inflation or a deeper-than-expected recession, could impact future returns. Therefore, an active management approach is necessary to navigate fixed income markets.
Important Information
This material is provided by Aegon Asset Management (Aegon AM) as general information and is intended exclusively for institutional and wholesale investors, as well as professional clients (as defined by local laws and regulation) and other Aegon AM stakeholders.
This document is for informational purposes only in connection with the marketing and advertising of products and services, and is not investment research, advice or a recommendation. It shall not constitute an offer to sell or the solicitation to buy any investment nor shall any offer of products or services be made to any person in any jurisdiction where unlawful or unauthorized. Any opinions, estimates, or forecasts expressed are the current views of the author(s) at the time of publication and are subject to change without notice. The research taken into account in this document may or may not have been used for or be consistent with all Aegon AM investment strategies. References to securities, asset classes and financial markets are included for illustrative purposes only and should not be relied upon to assist or inform the making of any investment decisions. It has not been prepared in accordance with any legal requirements designed to promote the independence of investment research, and may have been acted upon by Aegon AM and Aegon AM staff for their own purposes.
The information contained in this material does not take into account any investor's investment objectives, particular needs, or financial situation. It should not be considered a comprehensive statement on any matter and should not be relied upon as such. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to any particular investor. Reliance upon information in this material is at the sole discretion of the recipient. Investors should consult their investment professional prior to making an investment decision. Aegon Asset Management is under no obligation, expressed or implied, to update the information contained herein. Neither Aegon Asset Management nor any of its affiliated entities are undertaking to provide impartial investment advice or give advice in a fiduciary capacity for purposes of any applicable US federal or state law or regulation. By receiving this communication, you agree with the intended purpose described above.
Past performance is not a guide to future performance. All investments contain risk and may lose value. This document contains "forward-looking statements" which are based on Aegon AM's beliefs, as well as on a number of assumptions concerning future events, based on information currently available. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance, and actual outcomes and returns may differ materially from statements set forth herein.
The following Aegon affiliates are collectively referred to herein as Aegon Asset Management: Aegon USA Investment Management, LLC (Aegon AM US), Aegon USA Realty Advisors, LLC (Aegon RA), Aegon Asset Management UK plc (Aegon AM UK), and Aegon Investment Management B.V. (Aegon AM NL). Each of these Aegon Asset Management entities is a wholly owned subsidiary of Aegon Ltd. In addition, Aegon Private Fund Management (Shanghai) Co., a partially owned affiliate, may also conduct certain business activities under the Aegon Asset Management brand.
Aegon AM UK is authorised and regulated by the Financial Conduct Authority (FRN: 144267) and is additionally a registered investment adviser with the United States (US) Securities and Exchange Commission (SEC). Aegon AM US and Aegon RA are both US SEC registered investment advisers.
Aegon AM NL is registered with the Netherlands Authority for the Financial Markets as a licensed fund management company and on the basis of its fund management license is also authorized to provide individual portfolio management and advisory services in certain jurisdictions. Aegon AM NL has also entered into a participating affiliate arrangement with Aegon AM US. Aegon Private Fund Management (Shanghai) Co., Ltd is regulated by the China Securities Regulatory Commission (CSRC) and the Asset Management Association of China (AMAC) for Qualified Investors only; ©2022 Aegon Asset Management or its affiliates. All rights reserved.