Strengthening your core

Working investment grade bond portfolios harder

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Article Type
BondTalk
Topic
Credit
Published
March 26, 2025
Read time
5 mins
Author
Alexander Pelteshki, CFA
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With credit spreads close to 25-year lows, investment grade exposure is expensive, making a passive or ‘buy and hold’ approach less appealing. Here, we examine the current backdrop for the asset class and explain why 2025 could be a prime year for active credit management.

 

‘All-in’ yields remain compelling

Overall yields remain high within investment grade markets, making them attractive. The backdrop of low but positive levels of growth and inflation should allow central banks to lower interest rates in the period ahead, which is supportive of bonds. Furthermore, periods of moderate growth have historically been a sweet spot for investment grade bonds to perform.

 

As a result of these historic yield levels, market demand for investment grade credit has been relentless. Money market flows have reversed as investors seek yield to compensate for falling cash rates, while large institutional buyers, such as banks, insurers and pension funds, are locking in the attractive yields on offer. This strong technical support has strengthened the market, even as spreads continued to narrow.

 

Chart 1: US Investment Grade Corporate Bond Index Yield vs Spread

Source: Bloomberg as at 14 February 2025

 

Credit spreads – less room for surprises 

Credit spreads are now extremely tight, with the Bloomberg US Corporate Bond Index sitting at around 80bps. This increases the risks for corporate bonds, even in a non-recessionary environment. Furthermore, valuations become even less attractive further down the curve.

 

Over the past decade, until 2022, investors typically received around 30bps of additional compensation for extending from 7yr to 30yr credit. However, given investors’ reach for longer exposure, the credit spread curve has inverted into negative territory. This means there is virtually no compensation for extending credit duration, as shown on the credit spread differential chart below.

 

Chart 2: US Investment Grade - Credit spread curve. 7 year vs 30 year

Source: Bloomberg as at 14 February 2025

 

So what’s next for credit?

Although the macroeconomic backdrop is positive, corporate bonds face an important set of cross-currents.

 

Geopolitical risk remains heightened. Although the market has priced in some of the ‘Trump tariff' related fears from the turn of the year, and investors have adjusted their positioning, there is still a sense of uncertainty about what’s next.   

 

It’s still a relatively mixed macro picture. Employment is firm, but there are signs of some softer inflation and PMI data emerging, which, at the time of writing, has led government bond yields to rally somewhat.  

 

Demand for the asset class has been strong and will likely remain so through 2025. However, any material downward movement in yields could impact this support, and the timing or scale of any halt or unwinding is also unknown at this stage.

 

To be clear, we do not anticipate a credit event or an imminent recession in the next 9-12 months. In fact, things will most likely be quite benign, in the very near term at least. However, at these levels, we are cautious that there would not need to be an economic slowdown for spreads to widen.

 

Working investment grade portfolios harder

While it is impossible to predict the catalyst for a repricing, the lack of room for error makes spread investing challenging.

 

The backdrop favours a lower level of market risk – or credit beta – in portfolios and a greater focus on attractive bottom-up opportunities.

A global remit maximises the opportunities within investment grade, identifying ideas across different currencies, geographies, maturities, sectors and capital structures.

 

This is an inflection point in the cycle. Now is not the time to be slavishly following the index, and we believe it is as important to have as much conviction in what you don’t own as the positions you do.

 

The key to success lies in having dedicated resources to do the deep, fundamental analysis, alongside proven portfolio management experience of constructing high conviction portfolios.

 

At Aegon Asset Management, we currently see opportunities in several areas.  

 

  • Shorter-dated credit – due to the high cost of longer-dated credit, we have reduced credit spread duration in our investment grade strategies and skewed our risk towards the front end of the curve. This offers some protection against wider spreads while maintaining a solid level of recurring yield.
  • Balanced currency exposure – since late 2022, we have benefitted from more attractive spread opportunities in both euro and sterling credit. Their strong performance now offers an opportunity to rotate and take profits, enabling a more balanced currency approach.
  • Less ‘tariff-sensitive’ names – we are well positioned to capitalise on opportunities in banks, real estate and utilities, which are less sensitive to the ongoing ‘Trump Tariff’ uncertainty.
  • Banks higher in the capital structure – we still favour banks but now see better value higher up the capital structure: preferring Tier 2 debt over more expensive AT1 debt, while reducing the underlying credit market risk.
  • European and UK real estate – alongside a supportive rates outlook, we see opportunities in companies that are improving their fundamentals through self-help measures.

 

Focusing on a high-quality, defensive income stream seems a sensible way of earning a strong return, while minimising exposure to broad market risks and positioning for a potential widening of spreads.

 

Important Information

Author

Alexander Pelteshki, CFA
Portfolio Manager
Alexander Pelteshki, portfolio manager, is a member of the investment grade and multi-sector portfolio management team. He specializes in top-down asset allocation, global strategic bond and global credit portfolios.
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