Alexander Warren, Investment Analyst, Lonsec
Despite higher fixed income yields, tight credit spreads raise an important question: are investors being adequately compensated for the risks they take? Government bond yields have continued to rise since their COVID lows, lifting income across fixed income markets. Alongside tight credit spreads, however, investors receive less compensation for absorbing credit risk and have less protection if spreads widen.
The challenge for investors is to look beyond headline yields and understand what drives returns. Investors must consider how managers are adjusting their credit exposures, finding relative value across the credit universe and selecting securities. When considered against the backdrop of a prolonged credit cycle, disciplined portfolio construction and the ability to adjust risk as conditions change become increasingly important.
Attractive yields, but tight spreads
Government bond yields have risen sharply in recent years, increasing the potential return offered to investors in fixed income markets.
Credit spreads have continued to narrow since 2022 and remain low relative to longer-term history in much of the investment grade market. Tight credit spreads mean investors receive less compensation over government bonds for assuming corporate credit risk. An attractive headline yield does not necessarily mean investors are being adequately compensated for the credit risk assumed.
With tight spreads the premium available to absorb adverse developments is more limited, creating an asymmetric return profile. The immediate risk is not necessarily a rise in defaults, but rather spread widening alongside limited scope for further tightening to offset losses.
The nature and extent of this risk varies across the credit spectrum, depending on the structure and underlying exposures. This reinforces the importance of assessing where risk is being taken, the compensation received for it, and how portfolios are positioned to withstand a deterioration in market conditions.
Not all credit risk is the same
Credit investments carry different risks depending on quality of the borrower, debt seniority and the underlying assets. High-quality investment grade (IG) corporate debt is characterised by strong issuer fundamentals and lower default risk. These issues tend to be more liquid than lower rated or more complex debt and provide contractual coupon payments. Unlike dividends, bond coupons are contractual payments rather than discretionary distributions, although payment remains subject to the issuer’s ability to meet its obligations.
Credit risk depends primarily on issuer creditworthiness and structural priority. Issuers are broadly organised by ratings based on default probability. Below higher-grade IG debt sits high-yield (sub-IG) bonds, which carry greater macroeconomic sensitivity, default risk and higher yields. Within a single issuer, debt is also ranked by liquidation priority. Senior debt has the first claim on assets in default, with subordinated and mezzanine debt ranking below it. Securitised assets pool individual loans and engineer a separate risk ladder, with first-loss or equity tranches absorbing losses first, followed by mezzanine and senior tranches. Greater subordination beneath a tranche can provide more protection, but the level of protection depends on the collateral and structure.
Where is the value?
Tight spreads are prompting managers to reconsider the extent of their credit risk exposures, where they take it and what other sources of return can drive outperformance. Responses vary among managers and largely depend on fund benchmarks, duration capacity and mandate flexibility.
Staying invested but taking less credit risk
Some managers are reducing credit exposure, relative to their benchmarks or normal positioning, citing limited compensation and asymmetric downside risk. Such a stance provides greater protection if spreads widen, but risks underperformance if spreads continue to tighten or remain stable. Underweighting credit also leaves capacity to increase credit allocations should spread widening create future opportunities.
Some managers also note the importance of tail risk hedging to protect portfolios against sharp changes in market volatility. Tail-risk hedging aims to limit losses against sharp repricing, allowing portfolios to retain core holdings without materially reducing existing exposures. These strategies come at a cost, however, and can detract from returns if conditions remain stable.
Income, quality and duration
With tight credit spreads and higher government bond yields, spreads make up a smaller share of total yield.
For credit funds benchmarked to cash, higher base rates lift income, but return hurdles sit above cash and depend on spreads to deliver excess returns. With tight spreads offering little above base rates, higher than average income can coexist with periods of underperformance. Some credit managers are responding by capturing the higher income available from base rates, while prioritising portfolio quality and relative value over taking additional credit risk, alongside modest duration where mandates allow.
For funds benchmarked to bond indices, there is more scope to actively manage duration. With limited potential for credit spreads to drive outperformance, some managers are placing more weight on government bond income and duration, alongside higher quality exposures, for both income and downside protection.
However, government bonds face their own risks. Rising public debt and limited government willingness to address it could push long-term yields higher, and if this coincides with wider spreads, their protective role could be undermined.
Selectivity within credit
Managers also point to varying opportunities within credit, emphasising active security selection across issuers, sectors, maturities and capital structures. This includes focusing on higher quality issuers with resilient earnings, where the risk of asymmetric outcomes is lower. Beyond issuer selection, managers are looking to securitised assets, such as residential mortgage-backed securities (RMBS) and asset-backed securities (ABS), semi-government bonds or select global markets to drive returns. Securitised assets typically offer wider spreads than similarly rated corporate bonds because of differences in collateral, structure and liquidity.
The credit cycle we haven’t had
Credit market resilience has not been tested by a prolonged economic downturn since the GFC. While COVID-19 shocked global economies, the downturn was short lived as fiscal and monetary support helped limit credit stress.
A prolonged downturn, which would see weaker earnings and rising defaults, could expose vulnerabilities that have remained less visible during the period of generally supportive credit conditions seen since the GFC. Tight credit spreads leave investors with less cushion to absorb adverse developments and reinforces the weight placed on portfolio positioning. Against this backdrop, a manager’s ability to identify vulnerabilities and adapt portfolio exposures as market conditions change becomes increasingly important.
What does this mean for investors?
With credit spreads low relative to long-term averages, investors assessing fixed income opportunities must compare more than headline yields. A fund’s benchmark and mandate flexibility determine how much a manager can adjust duration and credit risk, which shapes where returns are generated. Investors should then assess the credit risk being assumed and how portfolios may respond if conditions deteriorate, with greater emphasis on a manager’s positioning, credit quality, security selection, hedging and liquidity.
High-quality active managers become particularly relevant in complex macroeconomic environments, as flexibility to adjust exposures, identify value and seek opportunities beyond corporate credit can help navigate market conditions and manage downside risk. But flexibility alone does not guarantee better outcomes. Investors must ensure they are being adequately compensated for the risks being assumed and whether their portfolio is positioned to deliver resilient returns should conditions deteriorate.
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