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Author: Paul Ackers

Investment grade (IG) corporate bonds provide a range of strategic benefits:

  • They provide a reliable source of income, typically with a return premium over government bonds (helpful to meet benefit payments for pension schemes).
  • The "pull to par effect" offers certainty of return for bonds held to maturity (assuming no default losses).
  • Interest rate hedging — IG bonds have an inherent sensitivity to interest rates, meaning that they can contribute to the risk reduction of liability hedging programmes, thus reducing leverage.
  • Given its key role in insurer portfolios, IG credit has the potential to hedge insurer pricing for pension funds targeting buy-out (we explore this point in more detail in a future piece scheduled for release soon).
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Despite these strategic advantages, the "entry point" for IG credit (i.e. the prevailing credit spread at the time of purchase) is critical. In this instalment, we'll consider the relationship between the starting credit spread and future returns. We'll draw an important distinction between short and long-dated credit and assess whether a strategy that switches between the two based on prevailing spreads can enhance returns.

What is the current market backdrop?

Demand from insurance companies, well-funded pension funds and other investors attracted by higher absolute yields have provided a supportive backdrop for IG credit in recent years. On the supply side, solid corporate fundamentals and reduced issuance of longer-dated debt from companies keen to avoid locking into current yields have provided further tail winds. These factors have contributed to a sustained period of tightening in credit spreads, leading to US credit spreads recently hitting historic lows, with current US and UK spreads at the fifth and 18th percentile respectively, based on monthly data since 1996.

Why do credit spreads matter?

Credit spreads are the difference in yield between corporate bonds and government bonds of equal maturities. They provide a good indication of the future return an investor may expect to achieve on corporate bonds over and above investing in government bonds (the excess return), assuming no defaults occur.

Measuring returns relative to government bonds (as opposed to all-in yield) is particularly important for pension schemes as they typically discount their liabilities using government bond yields, with an allowance for higher investment returns.

Below, we plot historical credit spreads (using monthly data back to 1996) against the excess returns achieved in the subsequent three-year period (if you were to invest into IG credit at the prevailing spread).

The chart illustrates that the higher the credit spread at the point of investment, the higher the returns over the subsequent three years. The correlation between credit spreads and future returns has historically been around 70%.

Another way of analysing the impact of credit spreads on future returns is to assess the probability of achieving positive returns over various time periods.

The chart shows that the lower the credit spread at the point of investing, the lower the likelihood of achieving positive returns in the following years. As credit spreads at the point of entry increase, the likelihood of achieving positive returns meaningfully increases, particularly when looking at longer time horizons.

Why does this behaviour occur?

Credit spreads have historically shown a significant level of reversion back towards their average levels. This means that credit spreads tend to provide returns from two different sources:

  • Higher credit spreads mean that you earn higher carry (the interest earned from holding the bond); and
  • Higher credit spreads mean that it's more likely that spread tightening will occur in the future, leading to further gains over and above those from the carry.

Similarly, when credit spreads are tighter, the carry that you earn is low, and based on historical data, there's a higher probability that spreads will widen (relative to the probability that they'll tighten further), leading to losses on the portfolio. The level of credit spread carry compared to the expected losses from spread widening largely determines whether future returns are positive or negative.

Is this behaviour the same for all credit?

As mentioned above, the losses from spread widening are a particularly large driver of returns when credit spreads are tight. Similarly, the gains from spread tightening are a large contributor to returns when spreads are high. Gains (or losses) from spread widening can be approximated using the formula:

Gains (Losses) from Spread Tightening (Widening) = Credit Duration x Spread Tightening (Widening)

The higher the credit duration, the higher the potential impacts from credit spread widening and tightening. At times when credit spreads are low, there's limited potential to gain from spread tightening (spreads typically have a lower bound of 0 as investors typically usually wouldn't buy a corporate bond with a spread of 0 vs. an equivalent government bond with a lower risk of default, although there have been some exceptions to this rule as of late).

Therefore, when credit spreads are tight, it can make sense to invest in shorter duration credit rather than long-dated credit to reduce the potential impacts of spread widening (which have become more likely based on the mean-reverting nature of credit spreads). We can see this impact in the chart below.

When credit spreads are tight, the probability of achieving positive returns for long-dated credit has historically been minimal. However, for short-dated credit, there remains a reasonable likelihood that returns will be positive. We can see for both short-dated and long-dated credit that the probability of positive returns increases as spreads widen, but this behaviour is much stronger in long-dated credit.

What about the premium for investing in longer-dated credit?

Theoretically, when investing in longer-dated credit, all else being equal you would expect to be paid more than when investing in shorter-dated credit (e.g. due to lower liquidity, and an increased probability of default over a longer time horizon). This is known as the "term premium". In the chart below, we show how the spread differential (the difference between long-dated and short-dated credit spreads) has changed over time in the US and the UK.

As expected, the US data shows that investors have generally been rewarded with higher spreads for investing in longer-dated credit. However, compared to recent history, the spread differential is not at a particularly attractive level. In the UK, the spread differential has averaged marginally above 0, in line with current levels.

Accounting for the higher spread offered by long-dated credit, we consider the spread widening that would be required to eliminate three years’ worth of credit spread carry:

Spread Widening (bps) to Wipe Out 3 Years of Carry Short-Dated Long-Dated
UK 58 26
US 50 21

To put this into context, we show the results as the number of annual standard deviation moves that would be required to wipe out three years of carry, based on the standard deviation of historical credit spreads:

Number of Standard Deviations to Wipe Out 3 Years of Carry Short-Dated Long-Dated
UK 1.0 0.6
US 0.6 0.3

We can see from the results above that short-dated credit spreads offer much more resilience against losses from credit spread widening due to their lower credit duration.

The lack of an attractive term premium in both markets, at a time where there appears to be an asymmetric return profile from spread movements, combined with the additional resilience against spread widening offered by short-dated credit supports the case for shortening the maturity of credit assets given current market conditions.

Can switching between Long and Short-Dated Credit be beneficial?

We’ve reasoned above that now may be a suitable time to shorten the duration of credit given the low credit spread environment. Similarly, if credit spreads were meaningfully above the historical average, there would be a strong case to lengthen the duration of credit portfolios.

So, could switching between long and short-dated credit based on market timing improve returns?

Below we illustrate the back-tested performance of a strategy that buys long-dated credit when credit spreads are above 190 (the 70th percentile historically) and switches to short-dated credit when spreads fall below 135 (the 30th percentile historically). We've allowed for transaction costs of 0.5% each time a switch is made.

Despite holding long-dated credit for over 60% of the time in the back-test, after accounting for transaction costs the combined strategy meaningfully outperforms long-dated credit (by 0.4% p.a.) and outperforms short-dated credit (by 0.2% p.a.), showing that it can add value.

Note: Results shown are based on a simulated back test. Actual outcomes will depend on real world implementation and market conditions.

What are the key takeaways?

  • Credit spreads tend to "mean revert" (i.e. they tend to return towards their average level over time), meaning that higher spreads typically lead to higher future excess returns, while lower spreads lead to lower likelihoods of achieving positive excess returns.
  • Investors have generally been rewarded with higher spreads for long-dated credit, but the current spread differential to short-dated credit is not particularly attractive.
  • Short-dated credit offers more resilience against losses from spread widening compared to long-dated credit. Current market conditions — low spreads and limited term premia on long-dated credit — support shortening the maturity of credit assets.
  • A strategy that switches between long and short-dated credit based on prevailing spreads in each market can improve returns. Back-tested performance shows that such a strategy outperforms both long-dated and short-dated credit.

Author Information

Disclaimer

For Professional Investors only. Not suitable for Private Customers.

Gallagher Benefit Services is a trading name in the UK for Gallagher Risk & Reward Limited (Company Number: 3265272), Gallagher Communication Ltd (Company Number: 3688114), Gallagher Actuarial Consultants Limited (Company Number: 1615055), Gallagher (Administration & Investment) Limited (Company Number: 1034719), Gallagher Consultants (Healthcare) Limited (Company Number: 172919) and Redington Limited (Company Number: 6660006) which all have their registered offices at The Walbrook Building, 25 Walbrook, London EC4N 8AW. All the companies listed are private limited liability companies registered in England and Wales. Gallagher Risk & Reward Limited, Gallagher (Administration & Investment) Limited, Gallagher Consultants (Healthcare) Limited and Redington Limited are authorised and regulated by the Financial Conduct Authority.