By William Sokol, Senior ETF Product Manager at VanEck.
William Sokol, Senior ETF Product Manager, VanEck.
Corporate bond investors are faced with a challenge in the current environment: sacrifice income or take more risk.
Over the past decade, corporate leverage (measured by debt to EBITDA, or earnings before interest, taxes, depreciation, and amortization) has increased, particularly in the past year.
The portion of the market comprising BBB-rated bonds, the lowest rating within investment grade, increased by nearly $3 trillion and now comprises over 50% of the broad market.
Over the same period, credit spreads have steadily grinded tighter. While there are many factors behind this, the fact remains that an investor with broad corporate bond market exposure is earning less compensation while taking higher credit risk.
We believe that being selective is critical in this environment. Despite today’s tighter spread and overall yield levels, corporate bonds remain a crucial component of an overall bond allocation because of the additional spread over US Treasuries they provide. This can increase the overall yield of a core income portfolio without an investor having to go too far down the credit spectrum, assume additional liquidity risk, or add volatility. A smarter approach to corporate bonds can provide investors with the benefit of yield pickup and upside potential without having to assume too much risk. But what approach can investors take to achieve better outcomes?
Deviating from a broad market exposure can take various forms, and some broad categories of investment approaches are listed below.
Source: VanEck.
Approaches to investing in corporate bonds
A quality-oriented approach can be appealing in some environments, particularly in deteriorating credit environments and when market volatility is high, by avoiding bonds that may decline in value—for example, bonds at high risk of downgrade. Such an approach has historically worked in the high yield market over the long-term. However, within investment grade, where the absolute risk of loss from defaults is historically low, this can mean sacrificing substantial yield for a benefit that may not consistently outweigh the cost.
Alternatively, a “yield enhanced” approach, which selects the highest-yielding bonds, may increase yield potential, but not without substantial risk. In general, higher yields should reflect higher risk, and given that there is generally more downside than upside in bonds, the margin for error may be slim. A naive strategy that simply selects the highest-yielding bonds, even if controlling for other risk factors such as duration, can introduce significant downside risk and result in underperformance.
We believe a strategy that focuses on valuation can be particularly effective in the investment-grade market. In other words, identifying bonds that provide high compensation relative to the level of risk assumed. Rather than focusing on absolute yield or spread levels, such an approach focuses on relative value and identifying mispricings where investors can capture additional spread over the “fair value” spread justified by the underlying risk of the bond.
The key is to accurately evaluate forward-looking risk and value in order to compare against market prices. Our preferred approach uses proprietary credit metrics developed by Moody’s Analytics to identify attractively valued bonds. Moody’s Analytics is the industry leader in credit risk modelling, and hundreds of the world’s largest institutions rely on their credit model for risk management and portfolio management decision making.
Using the Moody’s Analytics credit model, the broad investment-grade market can be parsed to identify and select bonds that are attractively valued (where market spreads exceed fair value) and avoid bonds that appear to be overpriced (where market spreads are less than fair value) and which may introduce downside risk to a portfolio.
Source: VanEck.
A broad market strategy that does not screen holdings based on valuation will, by nature, have substantial exposure to bonds with “negative excess spread.” In fact, the broad investment-grade market currently exhibits a negative excess spread, on average, meaning that investors are not earning adequate compensation for the risk they are assuming. The same is true for a “yield-enhanced” strategy which only considers yield levels without regard to risk.
A portfolio of attractively valued bonds allows investors to potentially earn an attractive yield in their core fixed income portfolio without taking excessive risk. Overall yield is not sacrificed through this approach, and, generally, investors have benefitted from a greater income return from attractively valued bonds versus a broad market exposure. In addition, these bonds have significant positive excess spread which provides upside potential as market prices potentially converge towards fair value over time.
The VanEck Vectors Moody’s Analytics IG Corporate Bond ETF (MIG US) seeks to track, before fees and expenses, the price and yield performance of the MVIS Moody’s Analytics US Investment Grade Corporate Bond Index which includes investment-grade corporate bonds that have attractive valuations and a lower probability of being downgraded to high yield compared to other investment-grade bonds.
The VanEck Vectors Moody’s Analytics BBB Corporate Bond ETF (MBBB US) focuses on the BBB-rated segment of the market and seeks to track, before fees and expenses, the price and yield performance of the MVIS Moody’s Analytics US BBB Corporate Bond Index.
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)