IG credit is starting to look attractive again

Investment Grade (IG) bonds have had a poor performance so far this year, as they were adversely impacted by high inflation, interest rate increases on both sides of the Atlantic and a rise in risk premiums.

Accordingly, the realized returns for an investment grade credit investor were negative by double digits in the first half of 2022, regardless of whether the investment was made in Euro, Global or USD investment grade credits. Losses of around 13% were incurred by European corporate bonds, by far the worst return ever achieved since the introduction of the euro.

This increase in risk premiums and interest rates has pushed the yield level of corporate bonds to a significantly higher level. The yield on the iShares Euro Corp Bond Large Cap UCITS ETF rose to 3.20% at the end of the first half of 2022 and is currently trading in the region of 3.15%. Around 1% comes from the interest rate side and a good 2% is attributed to the credit spread, which is meant to compensate investors for the additional risks associated with corporate bonds, like the risk of default. Comparably, yields in the US are roughly 1% higher and reflect the relatively more advanced stage in the rate hiking cycle

In an economic downturn, credit risks and risk premiums tend to rise to elevated levels. However, the widening of spreads in the first half of the year has already anticipated some of this development. To give some context to the returns currently earned on European investment grade credit, it is worth highlighting that since the introduction of the euro, there have only been three periods when euro IG credit spreads were higher than in the current environment.

At the height of the Lehman crisis, credit spreads rose to over 4.5%. At that time, it was a systemic crisis in which the continued existence of the banking system was in question. During the European debt crisis of 2010-2012, euro IG spreads peaked at more than 3.5%. This widening was not evenly distributed across the market, however, but was driven by the massive increase in credit risks of southern European banks and companies. This crisis was also systemic in nature. Finally, the spread maximum in the Covid-19 crisis in March 2020 was just under 2.5%. At this level, the European Central Bank intervened in the market to support spreads.

Moreover, there are other aspects that support credit spreads at current levels. Firstly, the quality of European companies’ balance sheets—like having ample liquid assets—has improved. In particular, leverage numbers are declining on average and for this reason, rating agencies continue to carry out more credit rating upgrades than downgrades. From November 2021 through July 2022, upgrades accounted for more than 60% of the ratings changes each month, but that number has evened out in August. Ultimately, the default rates of companies remain at very low levels according to an estimate by the rating agency Moody’s in its baseline scenario.

After years lamenting low yields, investors today have the possibility of earning relatively attractive returns from investing in IG corporate bonds. Unless a potential recession becomes very severe or turns into a systemic crisis, credit spreads have already realized much of their downside. The relatively safe investment grade segment could therefore attract investors who do not have an overly pessimistic view on the next twelve months.

Disclaimer: This article is brought to you by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd, which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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