Investment Grade Credit Midyear Report: A Challenging First Half, but Opportunities Remain

Rising interest rates generated negative year-to-date returns for investment grade bonds in 2021, but the second half of the year looks more promising. We believe the combination of reduced supply and strong demand will create attractive opportunities, and we are constructive on corporate credit and asset backed securities (ABS).

2021 Performance: Tighter Spreads Were Overshadowed by Rising Rates

The start of 2021 was a challenging period for investment grade (IG) fixed income investors, as rates increased substantially from their pandemic lows, creating losses across the IG spectrum. Investment grade corporates did not go unscathed, returning -2.85% year-to-date as of the end of May.

As we’ve discussed in previous corporate reviews, the asset class is vulnerable to rising rates as duration exposure remains near all-time highs – a natural consequence of corporations issuing longer maturity bonds to take advantage of record low yields during the past few years. The option adjusted duration (OAD) of the Bloomberg Barclays IG Corporate Index was at 8.59 years as of May 31 (vs. 7.10 on 12/31/18).

Fortunately, the interest rate losses were somewhat offset by tighter spreads, which helped corporate bonds outperform all other IG sectors. Spreads tightened throughout the period, ending May at 83.5 basis points, which is tighter than pre-pandemic lows.

Corporate OAS
Source: Bloomberg

IG corporates outperformed duration-matched Treasuries by 1.54% as of May 31, with spreads tightening 12.4 basis points over the period. As the economy showed signs of reopening, investors piled into areas exposed to higher risk in search of yield. BBB/Baa rated bonds particularly outperformed, as did longer maturity issues. In addition, spreads tightened materially in sectors that were most impacted by the pandemic, including Energy and Other Finance (which includes aircraft lessors, where we have been investing).