Aegon Asset Management: Fixed Income Opportunities: Evaluating Spreads vs. Yields

In our view, it’s not too late for fixed income investors to take advantage of elevated yields.

Spreads have narrowed, but yields remain attractive

Corporate bond spreads have narrowed to lows not seen since 2022. As the cycle extends and economy slows, it is no wonder investors are starting to worry about potential spread widening given the upside for capital returns is now more limited.

However, the attractiveness of asset classes can be evaluated using various metrics including yields, spreads, expected returns, etc. Many fixed income assets offer higher yields than has been normal in the last decade. Fixed income also offers enhanced income as coupon rates have reset higher. While spread levels look less compelling, all-in yields and higher coupons remain attractive.

Exhibit 1: Current yields are still well above 10 year medians

_{Source: Bloomberg as at 29 March 2023.} 

Past performance doesn’t predict future returns, but can yields?

Although spreads are tight, investors mustn’t lose sight of the bigger picture. Over the long term, the starting yield has been a steady indicator of future long-term total returns.

As shown below, the starting yield-to-worst for the high yield index has been close to the subsequent annualised five-year return. This relationship has generally held true in strong and weak economic environments, as well as periods with tight and wide spreads, With high yield corporate bonds offering a starting yield to worst around 7.7%, we continue to like the asset class on a yield basis.

Exhibit 2: Starting yields have been a reasonable estimate 5-year returns

ICE BofA Global High Yield Index monthly YTW and forward 5-year index returns

_{Source: Aegon Asset Management, Bloomberg as at 31 December 2023. Based on the ICE BofA Global High Yield Index. Past performance is not a guide to future performance.}

Enhanced breakeven rates

Even if spreads or yields widen from here, the breakeven rate for bonds is now considerably more attractive. The breakeven rate measures how high yields (or spreads) would need to rise before the total return of a bond becomes negative, typically over a one year time horizon. The total return of a bond has two components: price return and income return from coupon payments.

Prior to 2022, there was little income or yield available from newly issued bonds as markets had a prolonged period of low interest rates. However, as rates have shifted higher, yields across fixed income have risen and newly issued debt now offers higher coupon rates. Therefore, bond prices can now fall by a much greater degree before the total return becomes negative. For example, the yield on the US High Yield Bond Index can rise from the current level of 7.9% to over 10% - through wider spreads and/or higher core yields - before total returns break even. For US investment grade, yields can widen by 100 bps before investors lose money. This cushion is the biggest it has been for over a decade.

Exhibit 3: Enhanced breakeven profile for corporate bonds

_{Source: Aegon AM, Bloomberg as at 29 February, 2024. Based on monthly yield to worst data for the Bloomberg US Corporate and Bloomberg US Corporate High Yield index.  Past performance is not a guide to future performance.}

While there are attractive opportunities for fixed income investors to take advantage of current yields, we are cognisant that risks remain. While not our base case, reacceleration in inflation or a deeper-than-expected recession, could impact future returns. Therefore, an active management approach is necessary to navigate fixed income markets.

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