Because credit spreads are a measure of the additional return provided by corporate bonds over their government counterparts, it is important to consider whether corporate bonds offer compensation commiserate with their risk.
The increasing focus on credit
The growth in U.K. pension fund allocations to corporate bonds has occurred despite the fact that this buying pressure has caused corporate bond yields and spreads to fall sharply. While it might seem surprising, given the lowered potential for future returns, there are a number of points to bear in mind, in particular:
There has been a broad change in the risk appetite of pension schemes, resulting in more certainty regarding benefits payable, essentially removing the impact of future pension accrual as a diversifier to investment risk; These changes have reduced the interest of sponsors to devote resources to managing pension risk.
Both factors have led pension schemes to de-risk, and seek new sources of income. Moving into investment grade credit gives a relatively low-risk way of enhancing yields. Has the quest for yield, however, driven spreads to unnaturally low levels?
Evidence for a credit bubble–the counterfactual model
One way of looking at the question is to use counterfactual analysis. This involves describing the corporate bond yield curve over a particular period of time the "training period"–using a range of macroeconomic factors.
Counterfactual models do not describe the movements in the yields directly; instead, they look at the movement of the yield curve as a whole. We then compare the counterfactual yields with what we describe as the smoothed yields, rather than the observed yields.
The evidence suggests the current environment has produced a general quest for yield, and has likely resulted in yields being held far below predicted levels. But is this the only way in which yields should be judged?
Can companies cover their coupons?
Income cover, and the ability to maintain bond coupon payments, might be seen as a better measure of creditworthiness in this context.
The evidence refutes both the notion of a credit bubble and that corporate bonds are expensive; rather, it suggests that they are simply not as cheap as they once were. As such, despite corporate bonds not providing particularly good value, the issuing companies are, at least, more resilient now than before the financial crisis.
A global outlook
The conclusion that corporate bonds are not expensive, just not as cheap as they used to be, does not offer much of a clue as to what investors should do if they require additional yield. Perhaps the best advice is to adopt a global outlook-both emerging and developed markets offer something for investors.
Where do we go from here?
Unconstrained benchmarks are worth considering because they allow investment in a wider range of currencies and credit ratings. The broader the range of opportunities, the greater the yield that might be generated, and the more diversified the portfolio.