Are corporate bonds still profitable?

Valuations are always relative. This applies to both equity and bond markets. The benchmark is usually the “risk-free” investment. In practice, safety-oriented government bonds, such as US Treasuries or German Bunds, come closest to this term.

The risk premium for corporate bonds, also known as the credit spread, is widely used as a common valuation indicator for corporate bonds. This spread compensates the investor for the higher risk, which essentially consists of a higher default risk. But how should this credit spread generally be categorised and what does the current spread level tell us about whether corporate bonds are attractive or not?

Spreads on corporate bonds can be assessed from two perspectives: 1) in comparison to the historical level and 2) in comparison to the expected default rate. Depending on the perspective, different conclusions can be drawn.

Spread levels currently appear relatively narrow by historical standards

The comparison with historical spread levels can be particularly useful if one expects the spreads to approach their historical average sooner or later. A successful trading strategy based on this pattern requires a certain degree of market timing and therefore ultimately has a speculative component; by buying a corporate bond, the investor is betting that the spread will narrow and the price will therefore rise (assuming a constant general yield level). Although the timing of the markets always appears quite obvious in the rear-view mirror, looking forward this is generally much more difficult, although not impossible.

If we look at the spreads of global investment grade and high yield securities over time, we can see that the spreads are currently at the lower end of the range of the past 15 years and clearly below their 20-year average. Although the spreads, especially in the investment grade segment, were even lower before the financial market crisis than they are today, it is fair to say that corporate bonds no longer appear particularly cheap, at least from this perspective.

Past performance is not a guide to future performance.

Compared to the default risk, the picture looks somewhat different

If, on the other hand, you compare the spread with the default risk, you take the perspective of a “buy-and-hold” investor who intends to hold the bond to maturity. Such an investor is less interested in the interim movements in the spread levels (and corresponding price fluctuations), but mainly in the expected return to maturity, taking into account the probability of default. If this expected return is higher than the return on a “risk-free” government bond with the same term, it is worth investing in the corporate bond and thus taking on the additional default risk. In the opposite case, it is not worthwhile.

However, it is not possible to do this without making assumptions. For one thing, the future probabilities of default are unfortunately not known, and even in the event of a default, the investor usually receives a certain amount back after the insolvency of the company and the liquidation of the assets - a recovery value, so to speak. In order to obtain a realistic figure for the default rate, a recovery rate should therefore be factored in.

In order to make appropriate assumptions, historical average values can simply be used for both the probability of default and the recovery rate. Experience shows, for example, that a recovery rate of around 40% can generally be expected in the investment grade segment and around 30% in the high yield segment. For default probabilities, it can also be useful to think in terms of scenarios. For example, you could simply use the historical average as a base scenario and also take a stress scenario into account. For the latter, you could simply select the worst historical default rate in the period under review (e.g. during the financial market crisis).

If we compare the current compensation of corporate bonds in different rating segments with the historical default rates, taking into account the recovery rates described above, cumulated over 5 years in each case, we can draw the following conclusions (see chart below):

• The current compensation (green bars) is still well above the historical average default rates (blue bars), particularly in the investment grade segment (AAA to BBB) – despite the decline in spreads.
• The overcompensation compared to the average default rate decreases rapidly from the beginning of the high-yield segment (BB and above).
• The current compensation in the investment grade segment is even significantly higher than the worst default rates (red bars). Compensation in the BBB segment, for example, is still around twice as high as the cumulative five-year default rate during an extreme stress scenario such as the financial market crisis.
• If we were to face a major crisis like the 2008/2009 financial market crisis (which we do not expect), the compensation in the high-yield segment would not be sufficient. This means that in an extreme stress scenario, high-yield bonds would appear vulnerable.

Past performance is not a guide to future performance.

In conclusion, it can be said that although investment grade corporate bonds appear relatively expensive compared to history, compared to the potential default rates they can still be expected to yield a higher return to maturity than quasi-risk-free government bonds (e.g. German government bonds) with the same maturity. 

If one ignores possible price fluctuations in the interim, such securities can therefore continue to be worthwhile. The situation is somewhat different in the high-yield segment (and in particular from a rating of B). Although we can still find some interesting investment opportunities there, even greater selectivity is required here than in the investment grade segment. This selectivity in the corporate bond segment can ultimately only be provided by active management. 

The value of the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. The views expressed in this document should not be taken as a recommendation, advice or forecast.