Changing financial markets: corporate bonds in high demand

Investment-grade credit funds have been in high demand amongst investors for months, while government bonds are much less popular. This is surprising, as credit spreads on corporate bonds are currently not very high. However, a closer look reveals important reasons for this investor behaviour, which in our view also indicate that there is still more potential in corporate bonds.

Since the re-election of Donald Trump as President, the US has announced large-scale tax cuts to boost economic growth. At the same time, the US Federal Reserve is sticking to its quantitative tightening (QT) course. However, market expectations anticipate the QT to end soon. Intensive budget debates are also underway in Europe. The shift in the geopolitical balance requires defence spending amounting to several hundred billion euros. Germany’s recently announced massive investment package, the scope of which can be seen only in the necessary adaptation of the Basic Law, has led to the largest rise in interest rates on German government bonds since reunification.

However, the fiscal room for manoeuvre of many countries at the national level is limited – seven European countries, including France and Italy, are already in an EU excessive deficit procedure. Derogations for defence expenditure could remedy this situation. The classification of a strong defence as a “public good” of the EU could even pave the way for financing by the international community. For example, Europe is currently discussing whether to “reallocate” the Next Generation investment programme created during the Covid pandemic for rearmament, or to enable joint financing via the European Stability Mechanism (ESM).

Combined with trade warfare and the general trend towards protectionism, we expect inflationary pressures to persist, especially in the US, and the polarisation and intensity of the policy debate to continue. This creates an extremely fragile starting position.

The issue of fiscal sustainability has been closely associated with market players in Europe for more than a decade. The US, on the other hand, was long regarded as a safe haven, apart from sporadic tactics around the debt ceiling and largely ignoring the huge annual deficit. The US owes this status in part to the fact that the US dollar acts as a global reserve currency. In view of the uncertainties of a changing world order, a question mark must be raised here in the longer term. However, volatility has also increased significantly recently for US government bonds.

The price correction in October 2023 with a maximum drawdown of -18.8% on the US Treasury Index is more reminiscent of a risk-related rather than a safety component in the portfolio. The possibility of structurally higher inflation and the expected fiscal expansion have corrected the term premium, i.e. the compensation for the uncertainty of long-term interest rates, significantly upwards. While higher nominal interest rates compensate savers for inflation, the debate about the soundness of government finances inevitably raises the question of whether government bonds now generally include a credit element.

To answer this question, we compare government bonds and their yields to maturity with the yields on the swap market, i.e. the interest rates at which banks lend to each other. Depending on the creditworthiness of the government, government bonds pay less (better creditworthiness) or more (worse creditworthiness) return than the swap market of the same currency.

The spread of US government bonds over the USD swap has more than doubled since 2022 and is currently more than 44 basis points for ten-year maturities. This development shows that US Treasuries are not credit-risk-free assets either. Nevertheless, US Treasury yields have traditionally been seen as a benchmark for many other asset classes. A valuation on this basis can lead to a distorted judgement and must therefore be supplemented by other “benchmarks”.

For example, we also analyse the valuation of corporate bonds by comparing them not only classically with US government bonds but alternatively showing their performance against the USD swap market. A direct comparison of these two methods for calculating risk premiums (spreads) reveals the extent to which government bond and swap yields have decoupled. Do the risk premiums of corporate bonds seem expensive compared to government bonds – or are government bonds traded cheaply for good reason?

In contrast to swaps, however, corporate bonds currently trade close to the long-term average and thus compensate well for the solid fundamentals. Companies that are rated investment grade (IG) generally have a conservative, transparent and predictable financial policy and a very low default probability. The good fundamental situation of the companies is also reflected in the strongly positive rating development of recent years. For example, the share of IG companies with the lowest rating (BBB-) in the global universe fell from around 13% to less than 10% over the past four years. In addition, corporate bonds benefit from significantly better diversification compared to government bonds (the weighting of the largest issuer in the global IG corporate bond index is 1.6%).

Due to the risk premium, corporate bonds offer a higher yield than government bonds, but the realised volatility is currently lower than that of comparable government bonds. This is due to the negative correlation between government bond yields to maturity and risk premia.

The aforementioned risk premium also partially compensates investors for the lower liquidity compared to government bonds. Thanks to new technologies such as peer-to-peer and portfolio trading, liquidity in the corporate bond market has improved significantly in recent years. This is reflected in higher trading volumes, lower bid spreads and a decreasing liquidity concentration. We expect corporate bonds to continue benefiting from this development as the required liquidity premium – as part of the risk premium – decreases.

Corporate bonds have another trump card. Historically, government bonds have been the best choice for benefiting from price gains due to falling interest rates in a cycle of interest rate cuts. The prerequisite for this, however, is a steep yield curve.

On the other hand, short maturities were much better positioned for interest rate cuts based on an inverted yield curve. As the corporate bond market has a larger share of bonds with short maturities than the government bond market, investors with a corporate bond allocation can make tactical use of the short maturity segment.

Based on the arguments presented in this article, Swiss Life Asset Managers believes that global investment-grade corporate bonds, as a significant building block, can play a central role in an investor’s asset allocation. For experienced investors who want to position themselves optimally within the corporate bond segment in the current market environment, short-duration bonds are also well suited.