US Investment Grade Corporate Bond
By the Centrifuge Credit Group
Following our previous posts on US Treasurys and US Mortgage-Backed Securities markets, it is only natural to follow up with the third pillar that makes up the top three asset classes: US Investment Grade (IG) Corporate Bonds.
According to Allianz Global Investors, at $5.9 trillion, the US investment-grade corporate bond market is one of the largest and most liquid asset classes in the world. It can be an effective diversification tool, having historically demonstrated a low correlation to equities, US Treasurys and riskier fixed-income segments.
In this post, we provide an overview of this important market and explore the questions to ask when considering allocating to US IG credit, such as:
- How does the US IG market work?
- What are the different components of this asset class?
- How do they compare to each other?
- How has the safest segment of this market historically performed?
What is US IG Credit?
In traditional finance, US IG credit refers to the portion of the US corporate bond market that is rated at least BBB-/Baa3 or above. Just like the US government that issues government bonds called Treasurys that are backed by the full faith and credit of the government, big US corporations also issue company bonds called corporate bonds that are backed by the credit worthiness of the companies in question.
While every fixed-income instrument is subject to interest rate influence from the Fed, some of them don’t, in practice, have much credit risk. As we mentioned in our post on the US Treasurys, the yields on US Treasurys serve as the foundational benchmarks for other types of credit instruments. The further out of the credit risk curve we go, the more uncertain it is that issuers will be able to satisfy their legal obligation to pay interest and/or principal on time.
Unlike the US government, US companies cannot print money to ensure their debts are always paid. Due to the challenging business environment, companies could default on their obligation to pay. This is what is commonly referred to as credit risk.
To help standardize the conversation on credit risks, credit ratings are assigned to companies that want to issue corporate bonds by credit rating agencies such as S&P, Moody’s and Fitch.
The corporate bond universe can largely be separated into investment-grade and non-investment-grade buckets. An investment grade is a rating that signifies a corporate bond presents a relatively low risk of default. Below are investment grade ratings of the three major bond rating agencies:
Source: Investopedia
High-yield, or non-investment-grade or junk, refers to bonds rated Ba1/BB+ and lower. The main risks facing IG credits are:
- Interest rate risk
- Credit risk
- Recovery risk
Of course, there are countless ways to slice and dice the asset class, from idiosyncratic corporate names to specific parts of the IG universe and an index-based approach. While any single-name credit-focused analysis is beyond the scope of this post, we will focus on different parts of the IG credit space as well as an index-based approach.
IG Universe Unpacked
While picking out individual credit names requires deep credit analysis and is often the remit of a credit fund, taking advantage of a broad component of the IG credit space to target yield as well as diversification allows for strategic flexibility. To make the comparison easier to visualize, we will focus on the BBB part and the AAA part of the IG universe.
The best rating in the IG universe is the AAA grade. Triple-A-rated companies are entities of exceptionally high quality (established, with consistent cash flows) that have minimal credit risk. Focusing on AAA-rated bonds allows a study of minimum credit risk exposure possible.
Since there is extra credit risk (no matter how small) associated with the AAA-rated corporate bonds when compared to the US Treasurys and US Agency MBS, there should be extra yield to compensate for the additional risk. And of course, the further down we go in credit ratings, the more yield is required.
Let’s look at the difference in pricing the market has placed on the triple-A part and the triple-B part of the IG market.
Moody’s Aaa Corporate Bond, also known as “Moody’s Aaa” for short, is an investment bond that acts as an index of the performance of all bonds given an Aaa rating by Moody’s Investors Service. This corporate bond is often used in macroeconomics as an alternative to the federal 10-year Treasury Bill as an indicator of the interest rate.
As of January 2024, the average yield of Moody’s Aaa index is at 4.87%. In absolute terms, this is higher than the Covid period peak of 3.92% but lower than the global financial crisis peak of 6.47%.
What is interesting is that despite a much lower Fed Funds Rate, the index was yielding in a 5%-6% range between 2008-2010 vs 4%-2.5% in the 10-year US Treasurys. The market is placing a risk premium of 2%-3% on average to take on the credit risk of the safest US corporate bonds over equivalent government bonds. It is up to an investor to assess whether this premium is adequate to compensate for the extra risks associated with triple-A IG credit.
In comparison, the Moody’s Baa Corporate Bond index was at 5.68% by January 2024:
At these prices, the BBB part of the IG space is offering an excess yield of 81bps over the AAA part.
But how do we assess these numbers? Encompassed in these numbers are:
- Market assumption of the Fed’s rate and general economic conditions
- The default probabilities of associated credit ratings
- The economic and financial health of companies
The higher the Fed Funds Rate, the higher the floor for IG credit yield in general. Regarding the default probabilities, we need to refer back to historical data. According to an S&P 2021 Annual Global Corporate Default And Rating Transition Study, the associated one-year default rates for the different credit ratings since 1998 are:
Source: S&P 2021 Annual Global Corporate Default And Rating Transition Study
Of particular interest on this chart is the one-year default rate of different credit ratings. Using the 2021 data, both AAA and BBB credit had a default rate of 0 in 2021. However, the average for BBB is 0.20% while it is still 0% for AAA. While the absolute difference may be small, on a relative basis this means BBB is 20x more likely than AAA to default on average on a one-year time horizon. Does the extra 81bps of yield offered by BBB adequately compensate for the extra risk it poses to the investors? It depends.
- Does the extra yield, when taken into consideration the recovery rate, adequately compensate for the extra credit risk?
- On a price performance front, does the BBB index offer a superior return per unit of risk taken on a price-performance basis?
Put differently, what would be the minimum assumptions for economic growth rate, and by extension revenue, EBITDA growth rate, and recovery rate that would make the extra 2.3% yield worth the risk? This brings us to the metrics of corporate finance that assess a company’s ability to meet its obligations. Below is a graph showing some of the widely used metrics measuring the ability to meet debt repayment obligations:
Source: Alliance Berstein
What’s interesting about these charts is the story they are telling about the high-yield credit space (BB or lower) in comparison to their historical averages. Both net leverage and interest coverage are better than historical averages, suggesting improved fundamentals for the HY space.
Perhaps this suggests a similarly improved financial health for the lower end of the IG space, but that requires deep dive analysis on the makeup of the BBB debt universe that is beyond the scope of this post. However, the following framework may offer illustrative clues as to how to think about the question.
First, we need to have a better idea of the profile of the issuers of these BBB rated credits and analyze their financial health.
The chart shows a breakdown of the BBB growth between 2009-2018. The majority of the BBB growth comes from new issuance and downgrades from higher credit ratings. Issuers of BBB bonds by market weight are concentrated in the non-financial sectors that MSCI categorizes as defensive/non-cyclical, including health care, communications, and energy.
Breaking down the data further and isolating bonds issued by large-cap companies reveals an even more dominant concentration in non-cyclical sectors, with just the communications, health care, and energy sectors in aggregate comprising over â…” of outstanding bonds.
Of course, both the larger size of corporates in the BBB space as well as their non-cyclical businesses afford better protection in an economic downturn conceptually. To get a better understanding of their likely performance in an actual economic downturn, we should stress test their net leverage ratio (say assuming a 30% decrease of EBITDA) as well as the consequent coverage ratio while considering what levers they can pull to conserve cash.
Below are charts showing the historical ranges of the net leverage ratio and interest coverage ratio for non-IG grade credits:
Understanding if BBB-rated companies are likely to breach the HY level on these two measures gives us a better idea of their likelihood of defaulting or being downgraded, which would lead to higher financing costs and compound their financial difficulties in a challenging economic environment.
Another risk for BBB index-level performance would be the refinancing risk. The more supply the more likely it is to drive up yield and depress price. Doing this exercise would help us get a better idea of their likelihood of getting downgraded and/or falling into default.
An allocator may not require all these nuanced analyses. As we talked about in the previous post on asset allocation, if the objective is to simply satisfy a particular level of return requirement without taking on much credit risk, then deciding on whether to allocate to the safest part of the IG space on an index level may suffice.
Historical Performance of A-rated and Better
Using the ICE BofA US Corporate Index Option-Adjusted Spread, we can get a high-level view of the credit spreads of various credit rating categories over similar maturity US Treasurys is at the lowest in over 20 years.
On an absolute basis, all three credits are at the low end of their historical series despite the aggressive FFR hikes and the accompanying projection of economic gloom. When compared to historical averages, the market is pricing for little credit risk and very strong economic fundamentals vs US Treasurys of similar maturities. As an investor, you will have to decide if you are getting paid adequately for the extra credit risk you are taking at these levels.
Referring back to the S&P historical default rates for different credit ratings, we have the following:
| Default rate | AAA | AA | A |
|---|---|---|---|
| 2019 | 0.00 | 0.00 | 0.00 |
| 2020 | 0.00 | 0.00 | 0.00 |
| 2021 | 0.00 | 0.00 | 0.00 |
| Median | 0.00 | 0.00 | 0.00 |
| Average | 0.00 | 0.01 | 0.05 |
| OAS Spread | 0.40 | 0.54 | 0.82 |
As a matter of practicality, if an investor were looking to allocate a portion of their portfolio to single A+ rated corporate credit, what product offers them the access and how would this product compare to the US Treasurys options?
Unless the investor can construct their portfolio by accessing and purchasing each individual bond, the closest instrument at their disposal is the iShares Aaa - A Rated Corporate Bond ETF. This is an ETF focused on single A or better-rated US corporate bonds.
The effective maturity of the whole iShares Aaa - A Rated Corporate Bond ETF is 7.01 years while carrying an average yield-to-maturity of 5.26%.
How does this compare to the various segments of the Treasury market and the MBS market?
| Total Returns | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 |
|---|---|---|---|---|---|---|
| iShares $ Treasury 0-1yr ETF | - | - | 0.90% | -0.01% | 0.98% | 5.04% |
| iShares 3-7 Year Treasury Bond ETF | 1.36% | 5.78% | 6.88% | -2.51% | -9.59% | 4.50% |
| iShares 7-10 Year Treasury Bond ETF | 0.82% | 8.38% | 9.84% | -3.27% | -15.23% | 3.70% |
| iShares 20+ Year Treasury Bond ETF | -2.07% | 14.93% | 17.92% | -4.76% | -31.41% | 3.10% |
| iShares Aaa - A Rated Corporate Bond ETF | -2.30% | 12.54% | 9.81% | -2.22% | -15.31% | 7.58% |
| iShares MBS ETF | 0.81% | 6.27% | 4.03% | -1.27% | -11.86% | 4.99% |
| Effective Duration in years | Ave Yield-to-Maturity | Standard Deviation (3yr) | Ave YTM/SD | |
|---|---|---|---|---|
| iShares $ Treasury 0-1yr ETF | 0.29 | 5.24% | 0.71% | 7.38 |
| iShares 3-7 Year Treasury Bond ETF | 4.28 | 4.33% | 5.22% | 0.83 |
| iShares 7-10 Year Treasury Bond ETF | 7.21 | 4.29% | 8.48% | 0.51 |
| iShares 20+ Year Treasury Bond ETF | 16.58 | 4.51% | 16.92% | 0.27 |
| iShares Aaa - A Rated Corporate Bond ETF | 6.98 | 5.20% | 9.04% | 0.58 |
| iShares MBS ETF | 5.78 | 5.10% | 7.73% | 0.66 |
The Aaa-A-rated IG ETF is currently offering a risk/return profile most similar to that of the iShares 7-10-year Treasury Bond ETF. With a slightly shorter duration (lower interest rate risk) and a higher average yield-to-maturity on a portfolio level, the iShare Aaa-A-rated corporate bond ETF is offering an OAS-adjusted spread of 73bps. The bulk (84.2%) of the Aaa-A IG ETF is allocated to a single A credit, contributing to its spread premium.
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Source: BlackRock
Interestingly the volatility-adjusted return per risk of this IG category is below that of the MBS ETF. But the upside, as measured by historical return in 2023, was a 2.58% premium.
Crafting your investment mandate
The key areas to consider when it comes to the US IG credit space, in the context of asset allocation, include:
- Assumptions about the Federal Fund’s Rate
- Associated impact on the broad business environment and companies’ financial health
- Resultant impact on credit ratings and general ability to meet debt obligations
Putting this in an asset allocation context means evaluating the relative risk/reward such opportunities entail when compared to other asset classes such as US Treasurys and US MBS while taking into consideration one’s asset allocation constraints such as drawdown limit and liquidity requirements. Ultimately, the decision rests with investors based on their assumptions and investment objectives.
Disclaimer:
This post does not constitute or offer legal, tax, commercial or other advice and users of the post should not rely on it as such advice. Although care has been taken as to what is contained in the post, no attempt has been made to give definitive or exhaustive statements of law or any opinions on specific legal, tax or commercial issues and no representation is made or warranty given that the information is complete or accurate.
As more legislation and regulatory guidelines are issued or updated, the accuracy of the information contained in the post may alter. Anyone requiring advice on any of the matters referred to herein should consult lawyers or other professionals familiar with the appropriate jurisdiction and legislation.
Nothing contained in this post is to be construed as a solicitation or offer, or recommendation, to buy or sell any interest in any note or other security, or to engage in any other transaction, and the content herein does not constitute, and should not be considered to constitute, an offer of securities. No statement herein made constitutes an or to sell or a solicitation of an offer to buy a note or other security.
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