Does the hunt for yield equal the hunt for returns?

9 questions about credit investing | Question 2

Does the hunt for yield equal the hunt for returns?

The last two years have been a rollercoaster for bond investors, marked by 2022 being the toughest year since 1788. However, in the final months of 2023 the tides started to slowly turn, with yields falling from peak levels, as extreme inflation subsided, and investors grew more optimistic about a US economic soft landing.

With the rise in bond yields, bonds are back as an income stream for investors. But does the increase in yield necessarily imply higher total returns?

Analyzing investment grade credit returns in similar yield environments

Typically, yield is the most important determinant of longer-term bond returns, but in recent years, low and even negative yield environments have made capital gains the more important driver of bond returns.

However, now with higher yields, bonds are better equipped to absorb rising yields before total returns enter negative territory. While yields in most segments of the global fixed income market have risen, we see most attractive value in high quality credit which we define as investment grade credit and crossover (BB-rated) credit. These parts of the fixed income market offer an attractive yield with limited credit risk.

To assess the total return potential of investment grade credits in the current yield environment, we analyzed the twelve-month periods in the past 22 years that started with similar yield levels. We then calculated the total returns in those periods. In the figure below, we show the distribution of total returns from the 56 twelve-month periods in our research sample, each of which began with a yield level between 4% and 5%.

We clearly see that the probability of positive total returns is very high. In only three of the 56 periods, the total returns fell between -6% and 0%. The lowest total return observed was -3.0% while the maximum total return observed was 16.3%. The average return was 7.1%.

Distribution of total returns for global investment grade credit over a 12-month holding period

Distribution of total returns for global investment grade credit over a 12-month holding period

Source: Bloomberg, Robeco. Research period: March 2001-December 2023. This figure shows the distribution of the total returns of the Bloomberg Global Aggregate – Corporates index of all 56 twelve-month periods that started with a yield level between 4 and 5%. The displayed returns are unhedged and may differ from the currency of your country of residence. Due to exchange rate fluctuations, the returns shown may increase or decrease if converted into your local currency. Periods shorter than one year are not annualized. The value of your investments may fluctuate. Past performance is no guarantee of future results. This analysis does not represent a Robeco investment strategy and is for illustrative purposes only.

So, what does this mean for investment grade credit? Firstly, at current yield levels, investment grade credit has historically delivered positive total returns over a twelve-month period, in most cases when yields were similarly leveled. Even in years with further rises in bond yields, such as 2005.

Secondly, we mostly observed positive total returns over a twelve-month holding period, and in the majority of periods we saw annualized total returns between 6-12%. We must be cautious when replicating past returns to make predictions about future returns, but the direction of travel is clear. The current yield level on investment grade credit is very supportive for future total returns in various market environments.

Assessing investment grade credit returns in different economic scenarios

In a soft landing scenario where the US experiences sustained but moderating growth and inflation, central bank policy rates and bond yields are likely to gradually decline from current levels, while corporate spreads will trade more range bound. This environment is supportive for total returns on investment grade credit.

In a hard landing scenario where the US economy slides into a recession, central banks will likely be forced to cut rates more quickly causing bond yields to drop faster, as markets steer away from riskier assets into government bonds as a safe haven. Although spreads on investment grade credit could widen in this scenario, the drop in underlying government bond yields would mitigate the negative impact of the widening in credit spread and support total returns. Return correlations between equities and investment grade credit are typically negative in a recessionary environment, hence an allocation to credit could act as a hedge against softer returns in the equity space.

In an economic scenario where we see a strong rebound in inflation, we could see a further rise in bond yields. Yet, at current levels, investment grade credit should be able to absorb most of the negative impact of rising bond yields, thanks to the attractive carry return.

If history is any guide, and by looking at the different economic scenarios, we can conclude that in the global bond market, investment grade credit offers an attractive yield and total return potential with limited credit risk. In any market environment an active approach and thorough bottom-up fundamental research is always key to ensure that quality yield and return can be achieved without too much credit risk.