In today’s low-yield environment, many income investors are facing a conundrum. Reduce income levels in the name of lowering risk, or take on more risk to chase yield?
Investment-grade corporate bonds often split that difference. The widely followed Markit iBoxx USD Liquid Investment Grade Index is basically flat this year, and it sports a 30-day SEC yield of 2.09%. With default rates low across the corporate bond space, investment-grade corporates appear all the more appealing.
The asset class has a sturdy history, broadly speaking, but some market observers believe that its current risk/reward profile isn’t appealing.
“As yields trended lower over the last decade, investment grade bonds have offered investors reasonable yield of approximately 3%, relatively low risk of principal loss, and attractive total returns of just over 5% annualized,” according to BlackRock research. “Today, despite a favorable growth backdrop and expectations for low defaults, we believe the risk-adjusted reward in investment grade is increasingly unattractive.”
While the yield on the aforementioned Markit iBoxx USD Liquid Investment Grade Index exceeds what investors get with 10-year Treasuries, there should arguably be more compensation for taking on the added risk of corporate bonds. That’s not the case today, which is another way of saying that credit spreads are low — perhaps too low to make corporate bonds really worth it for income investors.
“The all-in yield on any corporate bond has two components: rates and an additional spread to compensate for risks such as credit risk and lower liquidity. Today, both components are at historically low levels, resulting in an all-in yield of just 2% for the Bloomberg Barclays US Corporate Index,” adds BlackRock.
With inflation potentially capping returns on investment-grade corporate bonds, the asset class could be vulnerable to rising interest rates. Regarding that, Federal Reserve Chairman Jerome Powell hasn’t signaled exactly when the central bank could boost borrowing costs, but it could happen as soon as 2023.
“After accounting for these more structural asset class changes and the ultra-tight spread backdrop, we increasingly view investment grade bonds as an asymmetric opportunity with more downside than upside,” concludes BlackRock. “In our portfolios, we’ve used the rally over the past year as an opportunity to reduce exposure in favor of assets that offer a more attractive range of outcomes and higher expected returns.”
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