Are bonds expensive?
Corporate bonds were a great investment in 2016. When hedged back to sterling, low-risk global investment-grade bonds returned just under 6%, while their riskier high-yield brethren were up 15%. That even compares favourably to global equities, which returned 8% in similar currency-hedged terms.
Much of that return came from tightening credit spreads over the year. The credit spread is the difference in yield between a corporate bond and an equivalent risk-free government bond. It represents the extra compensation an investor receives for the risk of the issuer not being able to repay the bond (defaulting).
The prices of all fixed income instruments are subject to the movements of government bond yields. However, corporate bonds receive an extra benefit from a tightening in spreads – or, are disadvantaged from a widening.
Unfortunately, while narrowing spreads are a boon for investors in terms of performance, they are also a cause for concern. The closer corporate bond yields get to those of equivalent government bonds, the harder it becomes to get closer still, and the less credit-risk compensation investors effectively receive. While performance can always be driven by the movement of underlying yields, there comes a point at which spreads are much more likely to widen than tighten, causing bond prices to fall.
Tightening spreads deliver positive returns despite rising yields
Last year, spreads widened until mid-February before beginning a tightening trend. Client portfolios benefited from our increasing exposure to high yield bonds in May. They continued to deliver positive total returns as their spreads further tightened, despite the headwind of rising yields after the US election in November.
The average spread on global investment grade bonds and global high yield are currently 1.2% and 3.9%, respectively. A comparison with history shows each bond category as being expensive but not excessively so. Since 2001 the average spread on investment grade bonds has been 1.5% and for high yield 5.8%. Current spreads are higher than they were in mid-2014. They are higher still than where they languished from 2004 to 2007 before blowing out as the global financial crisis hit (figure 1).
Government bonds are expensive, yet they have an essential role to play in diversifying equity risk in multi-asset portfolios. Within our credit allocation, we prefer high yield to investment grade bonds. While being mindful of spreads, the spread tightening we have seen is justified given the improving trajectory of the world economy and falling default rates. Credit returns are likely to be more constrained from here, but absolute levels of yield in high yield bonds (around 5.5%) are attractive given their short duration (approximately four years on average, globally), which will prove defensive if yields continue to rise.