Investment Grade Credit : An attractive risk-return trade-off for long term investors
As part of their portfolio’s capital allocation, wealth management clients tend to adopt a prudent approach with a long-term vision of wealth accretion. Such an investment strategy is usually constructed on a balanced portfolio spread across a variety of asset classes including real estate, equities, private equity, FX, hedge funds and fixed income products.
Fixed Income – credit - is a very specific market by virtue of its sheer size but also of its large number of sub-markets of different issuers such as sovereigns, municipalities, agencies, supra-nationals, corporates. In 2019, the Securities Industry and Financial Markets Association (SIFMA) estimated that the global equity market capitalization at the end of 2018 was approximately $74.7 trillion while the global bond market outstanding – just for listed bonds, a portion of the credit market - was estimated at $102.8 trillion.
The variety of credit investment opportunities and the characteristics of the various sub markets also make the credit market difficult to approach. Outside of sovereign debt, most non-professional investors tend to focus on the subset most familiar to everyone: corporate bonds, the listed portion of companies’ indebtedness, which is supposed to deliver long term regular yield at a margin above the risk-free rate. And this submarket can itself be broadly broken down in two depending on the credit worthiness and the underlying level of risk presented by these companies and these instruments: Investment Grade Bonds for the safest – typically high quality - companies and High Yield Bonds for the most risky.
The global financial crisis in 2008 originated as fundamentally a credit crisis. The historically low interest rates on sovereign debts incentivized investors to look for additional yield through complex structured credit products, but also through high yield credit. High yield bonds, often related to leverage buy-out investment funds’ acquisitions, can deliver good portfolio returns when the economy grows.
The entire premise of High Yield credit is to de-risk the investment over time through the deleveraging of the underlying company through:
- debt repayment
- and increasing operating cash flows.
However, while these products can deliver good returns in periods of economic growth, the most leveraged companies are also often those most at risk if there is a company-specific negative event or a market disruption.
When you look back at the evolution of bond market prices, in times of market dislocation, investment grade bonds are impacted and see a surge in effective yield (for example in 2008, IG yield peaked at approximately 9.3%) but the volatility of these investments is low compared to the volatility of high yield bonds, which peaked at approximately 23.3% (source: Compound), driven by the fear of bankruptcy for the issuers.
We come back to one of the fundamentals of investment: looking for the right Risk/Return balance. While High Yields bonds can deliver very good returns during periods of strong growth, Investment Grades bonds offer a lower return but generally fare better in time of crisis.
Investment Grades have historically been a relative safe haven for investors looking to achieve a regular long-term yield while limiting issuer risk. The evolution of the market during the 2008-2020 period also demonstrated this “flight to quality” momentum of investors during difficult times when uncertainty comes back to the market and volatility increases. Rather than cash deposits, Investment Grades bonds are an opportunity to deliver a mix of stability and income to investors trying to offset market volatility on the long term. The fact that the European Central Bank and the Federal Reserve announced that they intend to buy corporate bonds should also support this asset class.