How Advisors Can Stack the Investment-Grade Bond Deck in Clients' Favor

In bygone low interest rate environments, a traditional fix deployed by advisors was to transition away from low-yielding Treasuries and municipal bonds and into investment-grade corporates.

Exchanging duration risk for credit risk often worked in prior low-yield climates, but 2021 is proving to be a different beast for advisors and clients' fixed income allocations. Today, an issue with the duration-for-credit swap is that yields on the latter are low, too. The 30-day SEC yield on the widely followed Markit iBoxx USD Liquid Investment Grade Index is just 2.30%.

For clients that are likely to hold corporate bonds or the related funds for longer holding periods, that's potentially problematic because the lower a bond's (or a bond fund's) starting yield is, the more its upside is limited. Obviously, bond prices and yields move inversely, explaining why a low-yield starting can be more risky than many clients believe.

That ominous scenario can beget another one: Clients thinking they need to take on more credit risk in the name of generating more income and additional appreciation potential. Here's where advisors come in: There are alternatives to this risky strategy and they feature quality and income.

Corporate Bond Strategies Evolving

Fortunately for advisors and clients, broad-based approaches to credit are evolving. Gone are the days when relying on cap-weighted funds to access corporate bonds was the only game in town. That's good news because there's opportunity for advisors to steer clients away from traditional corporate bonds, many of which actually subject investors to more risk than they realize.

“We believe that being selective is critical in this environment. Despite today’s tighter spread and overall yield levels, corporate bonds remain a crucial component of an overall bond allocation because of the additional spread over U.S. Treasuries they provide,” says William Sokol, VanEck senior ETF product manager in a recent note. “This can increase the overall yield of a core income portfolio without an investor having to go too far down the credit spectrum, assume additional liquidity risk or add volatility. A smarter approach to corporate bonds can provide investors with the benefit of yield pickup and upside potential without having to assume too much risk.”

Advisors have several factor-oriented choices that can potentially boost fixed income results for clients. Those include quality, value and yield enhancement. Quality approaches are most applicable in environments where weak credit quality is prevalent and default risk is elevated. As for yield enhancing, that works in sanguine environments because it requires the client to take on more credit risk. It may be too early in the economic cycle for that approach to bear near-term fruit. That brings us back to value.

“We believe a strategy that focuses on valuation can be particularly effective in the investment grade market. In other words, identifying bonds that provide high compensation relative to the level of risk assumed,” adds Sokol. “Rather than focusing on absolute yield or spread levels, such an approach focuses on relative value and identifying mispricings where investors can capture additional spread over the 'fair value' spread justified by the underlying risk of the bond.”

By eschewing value in corporate debt, clients can be subjected to negative excess spread – a thorny scenario many old guard corporate bond funds are currently serving up.

Value Is Valuable

Good news: value is accessible with corporate bonds, that access is efficient and it could bear fruit for clients right off the bat.

“A portfolio of attractively valued bonds allows investors to potentially earn an attractive yield in their core fixed income portfolio without taking excessive risk,” says Sokol. “Overall yield is not sacrificed through this approach, and generally investors have benefitted from a greater income return from attractively valued bonds versus a broad market exposure. In addition, these bonds have significant positive excess spread, which provides upside potential as market prices potentially converge towards fair value over time.”

With those highlights in mind, advisors may want to evaluate the VanEck Vectors Moody’s Analytics IG Corporate Bond ETF (MIG). MIG, which debuted last December, holds 146 bonds deemed to be attractively valued with low possibilities of downgrades.

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