Investing in the 'sweet spot' of global credit

Within fixed income, we believe the crossover credit segment is one of the most promising strategies for income-orientated investors. These are bonds that straddle the line between the lowest investment-grade (IG) rating (BBB) and the highest high-yield rating (BB). History tells us that a combination of these bonds can provide the best risk-adjusted outcomes, making it the ‘sweet spot’ of global credit - always remembering of course that the past shouldn't be treated as a guarantee of future performance.

Fixed income: more attractive for income investors

After languishing for several years, interest rates and yields have returned to normal levels, enhancing the attractiveness of fixed-income assets. Credit spreads are a little on the rich side, but this is where increased bond yields can provide a valuable cushion against potential downside risks. Furthermore, corporate bonds currently offer good value compared to equities and cash. For example, the current global IG index yield of 4.5% [1] is well above the S&P 500 earnings yield of 3.4% [2] and the 4.3% [3] yield available from cash.

Focusing on the credit ‘sweet spot’

We see particular merit in focusing on BBB- and BB-rated corporate bonds. This ‘sweet spot’ has delivered some of the best risk-adjusted returns in global credit markets. 

Over the past 25 years, a 50/50 allocation to BBB-rated global IG bonds and BB-rated global high-yield bonds delivered returns similar to global high-yield bonds but with risk levels closer to global IG bonds. Currently, a 50/50 allocation would provide a US-dollar hedged yield of around 5.8%, which compares favourably to the US-dollar cash yield of 4.3% [4].

Source: ICE BofA indices, based on monthly US dollar hedged index returns for the 25 years to end-2024. * Note: ‘50/50 allocation’ refers to a 50% allocation to BBB bonds, coupled with a 50% allocation to BB bonds.

What explains the ‘sweet spot’?

In short: structural inefficiencies. The demarcation between IG and high yield corporate bond markets is somewhat artificial and arbitrary. Around this borderline, there will often be inefficiencies and cases where corporate bonds are incorrectly categorised relative to their evolving fundamentals.

A large and fertile hunting ground for yield generation and excess returns

The credit ‘sweet spot’ should also appeal to active investors due to the potential for mispricing at the individual security level. The sheer size and diversity of the opportunity set, with over 2,300 issuers across US, Pan-European, Asian and emerging markets, support the opportunities for yield generation and excess returns.  The ‘sweet spot’ also includes subordinated financial and non-financial subordinated bonds (i.e., corporate hybrid debt), which can provide significant tactical value at different points of the economic cycle.

Active bond investors who can spot mispricing and/or predict ratings transitions can potentially earn a significant additional return premium.

The home of rising stars and fallen angels

And then there are ‘rising stars’ and ‘fallen angels’. The former are bonds of companies currently rated high yield but whose credit fundamentals are progressing towards IG level. The latter are bonds rated as IG which have fallen into the BB (high yield) category. Both contribute to the strong risk-adjusted outperformance of the BB-ratings category. 

For ‘fallen angles’, the initial negative market reaction to the downgrade might be excessive, creating a buying opportunity. On top of this, issuing companies are incentivised to reduce financing costs by returning to the IG category. This can lead to debt restructurings or operational improvements that enhance the company’s performance.  Meanwhile, ‘rising stars’ retain their high yield as their credit financial health improves, offering better risk-adjusted returns. The market also often reacts positively to subsequent credit upgrades.   

In summary…

Higher yields have bolstered the attractiveness of fixed income. Within global corporate credit, we favour the crossover segment of BBB- and BB-rated bonds. We believe a careful, active approach within this large and diverse opportunity set can potentially deliver income and returns closer to high yield but with risk similar to IG. That’s why we believe it’s time to consider investing in the ‘sweet spot’ of global credit.