Yields on European investment grade credits have fallen so low that it is now time to sell securities in the asset class and look for a better deal elsewhere, says Lukas Daalder, Head of the Global Allocations team in Robeco.
Instead, the high yield, non-investment grade corporate bond market still offers a decent yield difference (spread) above sovereigns, and at relatively low default rates, he says.
Robeco Asset Allocation has subsequently decided to lower its exposure to investment grade credits by one percentage point and spend the money on high yield corporate bonds. The multi-asset fund is now underweight on investment grade, as it holds fewer bonds than the benchmark, and significantly overweight on high yield.
“European investment grade credits have shown a decent performance since 2009, leading to spread compression versus government bonds,” he says. “We see the corporate credit spread no longer as attractive, and a large part of the index spread is attributable to implicit country risk versus Germany.” Today, both investment grade credits and their sovereign bond peers yield around 1.5%-2%.
“However high yield bonds are still offering a decent credit spread, given their strong fundamentals, low default rates and the favorable regional mix, particularly in the US, despite the drop in high yield spreads in the last few years.”
Three reasons for the switch
Daalder gives three reasons why investment grade credits are not as attractive as they once were:
- Both the non-financial corporates and the financial credits index yield have dropped significantly in the last years, and are now moving in tandem with European government bond yields. This can be seen in the chart below:
Source: Bloomberg
- The index spread, measured against German Bund yields, is for a large part a compensation for the exposure to country risk against Germany. What people think is credit spread is actually country spread. For example, compared to the low German Bund yields, there still is a positive spread for various credits. However, if you compare it to national government bonds, which would be fairer, the spread is actually negative in many cases, as can be seen from the example of Unicredito in the chart below:
Source: Bloomberg
- Although the credit fundamentals of European credits and financial bonds still look good thanks to strong balance sheets, conservative behavior and a low interest rate burden, we think that the solid fundamentals are discounted by the market by now.
US allocation helps spread buffer
Daalder says the spread buffer is higher and regional exposure is more favorable in high yield than in investment grade, thanks partly to a large allocation that his fund has made to the US.
“Sure, the yield and spread on high yield bonds have fallen as well, but the ratio between high yield and investment grade yields still looks attractive, while high yield fundamentals remain strong,” he says.
“We see the overall fundamental picture as still supportive for high yield bonds. The interest rate burden is at an all-time low, while default rates remain at very low levels.”