How have corporate bond returns fared when spreads are tight?Tight spread environments can be a challenge for the returns of corporate bonds compared to government bonds. However, slim spreads do not necessarily spell disaster for corporate bond investors.The risk of underperformance arises when trading corporate bonds, as prices will fall if spreads increase to normal levels. However, for long-term investors, default rates on investment-grade (IG) corporate bonds have averaged just 0.1% per year over time, meaning 99.9% of these bonds don’t default annually. Although you are not getting compensated as much for lending out your money, it is not to say that holding to maturity won’t yield returns exceeding those from government bonds.Currently, overall yield levels are significantly higher than they have been in the past decade, providing a larger margin of safety against negative returns. On a 12-month view, IG bond yields would need to rise by 0.7%, and high-yield (HY) bonds by around 2%, before bondholders would face losses.Despite recent market volatility, USD spreads remain tight relative to history, with both IG and HY spreads near their post-global financial crisis lows. Tight spreads have historically led to weaker excess returns, as lower spread ‘carry’ reduces the room for bond price increases. Our analysis of over 27 years of data shows that tighter spreads consistently result in lower excess returns, though variability exists.Hit rate analysis, which measures the proportion of time excess returns are positive, further confirms this trend. When IG spreads are in the tightest decile, positive 12-month excess returns have been generated only 12% of the time, while HY bonds have a higher success rate of 41%.However, tight spreads don’t have to be awful depending on investment time horizon and perspective. Even in HY markets, where default rates can spike, the long-term average default rate has been around 4%, with recovery rates on defaulted bonds averaging 40%.With inflation falling and central bank rates expected to decline, corporate bonds may remain attractive to long-term investors looking to lock in elevated yields. Higher yields today have brought about a greater margin of safety, as IG yields would need to rise by 0.7% and HY by 2% before losses occur, offering reassurance to those concerned about future price declines.Want to search and invest in related funds?Open the WeLab Bank App and click【Featured Funds】to find out more!
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Schroder’s Insight: Corporate Bond
