Over the past 12 months, the yield on corporate bonds has been as much as minus 22 per cent. As a result, the effective yield on investment grade corporate bonds has now risen to 5.5 per cent at a duration of just over 6 years. This is in line with the return earned on investments according to the tax authorities, on which 31 per cent tax has to be paid this year.
At the same time, most banks still do not give interest on current account balances, but that is not subject to tax these days.
Bankruptcy of balanced portfolio
For years, there was no dry bread to be earned in the bond market. With low or even negative interest rates, investors knew in advance that the outcome would be exclusively negative. Even its role as a buffer in the event of a correction in the stock market had disappeared, which is now very noticeable.
As a result, a very defensive risk profile could no longer be advised with good grace. Then a savings account, although with no return but also no risk, was a better alternative. It also meant the bankruptcy of the balanced or neutral portfolio, a portfolio that in the decades before had actually shown returns comparable to equities, but with half the risk.
Due to the extreme price losses on bonds, the balanced portfolio is now also back. A year ago, the outlook for bond investors was extremely bleak. Inflation was already rising, but interest rates remained low. There was no conceivable scenario in which investment grade bonds left a real positive return. In fact, it was possible that over the next 10 years, real returns per annum could even be negative by 2 per cent on average. With the sharp rise in interest rates, all those negative returns compressed into 12 months.
Credit surcharge improves
It is time to become a bit more positive. In a recession, losses for investment grade bonds remain limited and because of their higher duration than high yield, they also benefit from falling interest rates during a recession. High yield bonds, on the other hand, see credit losses rise sharply in and after a recession. Although the current yield on high yield is at least presentable again, in fact not much more than the scenario of a soft landing is discounted, at least not a recession.
The big difference between investment grade bonds and high yield bonds is credit losses. Investment grade corporate bonds are bonds with a credit rating of BBB-/Baa3 or higher. The highest default rate in any year for AAA, AA, A and BBB corporate bonds is 0 per cent, 0.38 per cent, 0.39 per cent and 1.02 per cent, respectively, according to S&P. Now, the credit premium on BBB loans is easily above 2 per cent, up from 1 per cent a year ago.
In any case, sufficient remuneration for the risk to be run. If that is set against high yield bonds with credit ratings of BB, B and CCC, the historical default rates in the worst year are 4.22 per cent, 13.84 per cent and 49.28 per cent, respectively. Moreover, the recovery rate for investment grade defaults is higher than for high yield defaults. However, the interest rate sensitivity of investment grade corporate bonds is higher than that of normally shorter-term high yield bonds.
Thanks to sharply higher interest rates in the bond market, a bond portfolio is also once again an alternative for savers. Many bond investors were forced to save in recent years, but can now return to the bond market. A yield of more than 5 per cent can also compete well with all kinds of online money-lending options. Usually the fee is not that much higher than 5 per cent and there is a higher credit and liquidity risk on top of that. If these providers really want to compete with investment grade corporate bonds, the interest rate has to be a lot higher than 5 per cent.
Positive real total return
In a recession, these corporate bonds may even show the best return in a portfolio. Many risky assets are then under pressure, while interest rates can fall by 1 or 2 per cent. Together with the coupon yield, a return of more than 10 per cent could emerge. While that is less than the current inflation rate of 17.1 per cent, it is unlikely that the inflation rate will still be above 10 per cent in 12 months’ time.
A positive real total return in a recession is therefore in the offing, making corporate bonds a great fit for an investment portfolio again, although those who got in a year ago will have to swallow.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is one of Investment Officer’s knowledge experts. His contributions to Investment Officer Luxembourg appear from time to time but often on Thursdays.