IG Corporates – where high quality comes with attractive yields

The risk-return trade-off for global corporate bonds has improved significantly over the last two years. On the one hand, the duration has declined significantly, while yields (carry) have risen. Investors currently have the rare opportunity to secure an attractive yield with a very low probability of default, typical of investment grade corporate bonds. For 2025, we expect returns in line with current yield levels with the possibility of further price gains from a decline in rates. The higher level of policy rates gives central banks plenty of room to manoeuvre in the event of an economic downturn, which puts them in a comfortable starting position. Should global growth momentum and inflation decline, lower interest rates could have an additional positive effect on returns.

The US yield curve has already begun steepening since the front-end remains firmly tied to the policy rate outlook, while long-term yields have risen on a higher growth and inflation outlook. Historically, a resteepening of the rates curve has correlated strongly with outflows from money market funds as investors face reinvestment rate risk the longer they delay finding better yielding investments. With a record-high USD 6.5 trillion currently parked in money market funds, a further decline in policy rates may stimulate a rotation into high-quality bonds.

All-in yields for investment-grade corporate bonds (USD: 5.2%, EUR: 3.2%) remain elevated relative to historical averages, presenting attractive entry opportunities. Based on current market assumptions for the future shape of the yield curve, the yield differential between investment-grade corporate bonds and money market funds is anticipated to widen significantly to approximately 1.5% over the next 12 months. Inflows into high-grade bond funds have accelerated this year in anticipation of the first rate cut by the Fed, and the strong demand is expected to remain given the combination of elevated yield levels and the prospect of further rate cuts.

In addition, a gradual decline in policy rates, as currently expected by market participants, is better for credit spreads as opposed to a sharp cutting cycle. Reduced uncertainty around the rate trajectory will keep volatility low in US Treasury yields. This should be conducive to low or negative correlation between rates and spreads, which in turn improves risk-adjusted returns for corporate bonds, particularly in comparison to government bonds.

Within the investment grade corporate bond universe, the underlying credit quality has improved materially over the last few years. Upgrades have continued to outpace downgrades, resulting in a steady decline in the share of BBB-rated bonds. The positive rating migration has been the result of a decline in leverage ratios since the peaks in 2020.  Corporate issuers have prioritized paying down debt or retain cash to boost their balance sheet position as opposed to increasing capital spending or shareholder returns. We expect debt levels to grow at an average pace in 2025. Similarly, the economic growth outlook should be supportive to a proportionate increase in earnings. As a result, we anticipate corporate fundamentals to remain strong and stable over the next few quarters.

The favourable rates outlook and solid credit fundamentals thus present a compelling case for investors to start adding to their IG corporates allocation. As US exceptionalism is likely to stay, we have a preference for US entities with a strong domestic presence. We continue to like the healthcare sector given that many issuers remain on a deleveraging path despite valuations cheapening following the election. We also  like banks which should see continued strength in profitability from loan growth and a steeper curve while the regulatory environment should be friendlier. In Europe, we favour non-cyclicals over cyclicals and maintain a focus on sectors such as utilities and telecommunications.

Co-author: Krishna Tewari, Investment Strategist