Global corporate bonds: Effective diversification across regions and ratings

Summary

• This short study gives an overview of the global corporate bond market. It outlines the various segments within the universe, as well as the different drivers of return at the portfolio level.
• The paper explores the theory behind investing across a wide universe (investment grade, high yield and emerging markets) and also looks at actual examples.
• In the case of global corporate bonds, there are hardly any products that fully cover this spectrum in the way the MSCI World Index does for equities. As well as explaining why that is the case, this paper looks at how to invest across the entire investment universe, and also at what kind of investor this benefits.

Introduction

Corporate bonds are one of the most important asset classes in the entire universe. While they have a higher risk of default and are often less liquid than (risk-free) sovereign bonds of leading developed markets with the same maturity, corporate bonds compensate for this by offering an impressive excess return in the long term. Corporates usually differ with respect to credit quality (investment grade – high yield), domicile of the issuer (developed market – emerging market) and interest type (fixed – variable coupon).

What is striking is that the entire global corporate bond universe is rarely captured in one single product that systematically considers all sub-segments. Asset managers tend to offer corporate bond strategies in the three separate segments of Developed Market Investment Grade, High Yield and Emerging Market Corporate Bonds.

This short version of a study by Fisch Asset Management points out the opportunities for investors with corporate bonds denominated in hard currencies (USD, EUR etc.), and outlines the advantages of full coverage in one product.

 

Drivers of return and benefits of global corporate bond portfolios

A number of factors influence the return on a corporate bond portfolio:

• The credit quality of the bonds, as measured by their credit spreads.
• The interest rate sensitivity of the bonds, as expressed by their (modified) duration.
• The currency of the bond, due to differing movements in yield curves and in credit spreads between the individual markets.
• The currency of the bond due to movements in exchange rates if the currency risk is not systematically hedged into the base currency of the portfolio.

Active portfolio management assesses these factors to determine how attractive the bonds are for a portfolio (bottom-up analysis). However, the portfolio return is also influenced by top-down decisions, such as the overall credit and duration exposure, currency allocation, weights of issuer sectors, as well as regions, rating categories, and so on.

The sheer range of factors that influence returns gives an indication of the high demands placed on active management, but also the opportunities they present. In comparison with individual sub-segments (IG, HY, EM corporate bonds), the manager of a product that covers the entire global corporate bond market has more investment options, and therefore potentially attractive credit opportunities to choose from, thus allowing better diversification between the various risk factors. In addition, with the broader universe there is a greater chance of generating an excess return via active top-down allocation. The process of over- and underweighting the three sub-segments can in itself significantly influence the result.

The choice of benchmark for a strategy that covers the entire universe requires some explanation, as no industry standard benchmark exists (as yet). A Composite Index was defined for this paper. The advantage of this is the high level of transparency as well as the use of widely recognised sub-indices. Specifically, it comprises the Bloomberg Barclays Global Aggregate Corporate (65%), the JPM CEMBI Broad Diversified (25%) and the ICE BofA Merrill Lynch Global High Yield DM Index (HYDM) (10%), all EUR-hedged, with monthly rebalancing. The percentage weights roughly correspond to the breakdown of the global market volume.

Comparison of global corporate bonds with sovereign bonds

As is to be expected based on their higher yield to maturity, corporate bonds have generated higher returns than developed market sovereign bonds since 2002: 1.5% p.a. more than eurozone sovereign bonds (as measured by the ICE BofA All Maturity All Euro Government Index) and 1% p.a. more than US sovereign bonds (ICE BofA US Treasury Index EUR hedged). This excess return compensates for the fact that corporate bonds are 25-40% more volatile (see Chart 1).

Chart 1: Comparison of performance with volatility over 21 years

_{Quelle Fisch Asset Management, Bloomberg Barclays, JP Morgan, ICE BofA ML, as at 31/12/2022}

 

Corporate bonds have lower interest rate sensitivity and higher credit risk sensitivity than sovereign bonds. These two factors do not correlate perfectly. High yield bonds in particular have a low – and at times even negative – correlation with sovereign bonds. Supplementing a sovereign bond portfolio with global corporate bonds thus reduces the interest rate sensitivity and improves the risk/return ratio. For example, a portfolio of 50% eurozone sovereign and 50% corporate bonds with monthly rebalancing would have generated a 57-basis-point higher return per annum over the past 21 years with just a slightly higher volatility of 10 basis points p.a.

The influence of corporate bonds on a portfolio of sovereign bonds is very clear when we differentiate between months with a positive return on sovereign bonds and those with a negative one. In positive months, eurozone sovereign bonds on average generate a 16-basis-point higher return than global corporate bonds. In negative months, however, the difference is a much higher 51 basis points in favour of corporate bonds. The advantage of their lower duration and higher credit spreads thus pays off in periods of rising interest rates in particular.

Analysis of sub-segments within global corporate bonds

Owing to their higher credit spreads, high yield and emerging market corporate bonds are more volatile than investment grade developed market bonds even though they are less sensitive to interest rates on average. Higher returns compensate for this elevated risk. Since 2002, the Composite Index – which captures the entire corporate bond market – has generated a 72-basis-point higher return p.a. on a 66-basis-point higher volatility p.a. than DM IG corporate bonds (Bloomberg Barclays Global Aggregate Corporate Index).

Chart 2: Average monthly returns, 2002–2022

_{Source Fisch Asset Management, Bloomberg Barclays, JP Morgan, ICE BofA ML, as at 31 December 2022
The past 21 years were divided into periods of falling, rising and sideways-trending interest rates (as measured by the 10-year US-Treasury yield to maturity), where a minimum difference of 50 basis points between interest rate highs and lows determined which period they fell under.}

 

The advantage of wide coverage of the corporate bond market is apparent in various interest rate environments. In periods of falling interest rates, the average monthly return of the Composite Index was only slightly (4 basis points) less than that of DM IG bonds. In periods of rising interest rates, however, the outperformance of the Composite Index amounted to an average of 20 basis points. The less negative performance of emerging market bonds is a contributing factor. What happens with high yield bonds is even more striking. They generate a positive return in all three interest rate environments, thus stabilising the impact of the higher interest rate sensitivity of an investment grade bond portfolio.

Conclusion and investor perspective

Although global corporate bonds are an important segment of the varied universe of fixed-income securities, it is one that, in practice, is seldom fully covered in a standalone product. Empirically, there is much to be said for regarding corporate bonds as a separate sub-class of fixed income with their own allocation. In practice, then, the question is whether to invest in portfolios consisting of the individual sub-segments (investment grade, high yield and emerging markets), where allocation is determined by investors themselves, or to invest in products that cover the entire corporate bond market, where allocation between the segments is deliberately left to the portfolio manager. Although the former is more common in practice, the latter can be a valid alternative for some investors. It has advantages for three types of investor in particular:

• Investors with a focus on investment grade corporate bonds seeking a better risk/return ratio by dint of the “controlled” addition of high yield and emerging market bonds but who, for regulatory or other reasons, want/have to stick with IG.
• Investors who are consciously covering the entire global corporate bond market, but do not wish to invest separately in the individual sub-segments (IG, HY, EM) because the amount invested is too small or it would involve too much effort and therefore expense.
• Investors who want to cover the entire corporate bond universe, and would also be investing enough to do so in sub-segments, but consciously wish to let a proven credit specialist make the decisions concerning allocation and thereby generate an excess return. In this instance, it is often worth considering a tailored solution in the form of a mandate. The many influencing factors (credit quality, interest rate sensitivity, currency of issue, domicile of issuer, etc.) can thus be aligned with the investor’s individual needs.