IG Bonds: Valuation and Selectivity Matters

By William Sokol
Director of Product Management

With investment grade corporate bond yields providing meaningful income and with elevated market volatility, we believe there are now opportunities in mispriced bonds with attractive valuations.

A significant increase in both interest rates and credit spreads has made for a difficult year for investment grade bond investors. However, we believe the asset class is now attractive as we look ahead to 2023. With higher overall yields, corporate bonds are now providing significant levels of carry. Investors can once again earn meaningful income from their bond portfolios and expect more robust performance in various scenarios. For investment grade corporates, in particular, we believe current spreads are already pricing in a meaningful probability of a recession. Spreads are above their long-term average going back to 1996, unlike high yield bond spreads which continue to trade tight on that basis. In a slowing growth environment, we believe higher quality bonds may be an attractive option to maintain income while avoiding potential drawdowns, as there is far less spread risk at current levels.

Given the size and diversity within corporate bonds, we believe being selective can provide better outcomes for investors. In particular, focusing on attractively valued bonds has historically provided significant outperformance. The market is not homogenous, and there is significant scope for mispricing to exist. With the rapid and significant tightening of financial conditions this year, we believe additional pricing dispersion can emerge. Both rate hikes and growth concerns may create additional volatility, providing the opportunity for investors to benefit from relative value opportunities.

We define attractively valued bonds as those offering significant “excess spread” above “fair value,” meaning they offer a market spread that is greater than what’s needed based on the actual embedded risk. Moody’s Analytics calculates proprietary credit metrics to determine fair value. Moody’s Analytics is the pioneer in credit risk modeling, and is relied upon by hundreds of institutions globally for portfolio risk management and decision-making.

Focusing on high excess spread does not simply mean selecting bonds with the highest yield. Fair value considers factors including the probability of default, expected recovery rate, sector-specific considerations, and the level of systematic risk. Fair value also considers bond-specific factors, including the bond’s price, maturity, and seniority. By focusing on bonds with high excess spread, investors may earn a higher level of carry versus the broad market but also benefit from lower overall risk in terms of both the expected probability of default and the probability of being downgraded to high yield (which can have a significantly negative impact on investment grade bond prices).

Below we show a hypothetical strategy that selects the top 40% of bonds each month from the investment grade universe based on the level of excess spread and also a similar strategy focusing on BBB-rated bonds only. Compared to their respective broad market benchmarks, both achieved significant outperformance on an absolute and risk-adjusted basis.

Valuation Matters in Corporate Bonds – Investment Grade

Valuation Matters in Corporate Bonds – BBB

Valuation Matters in Corporate Bonds - BBB

YTD 1-Year 3-Yrs 5-Yrs 10-Yts Since 4/1/07 10- Yr Std Deviation 10-Yr Sharpe Ratio
U.S. IG Corporates -18.33 -18.19 -3.5 0.06 1.78 3.72 5.88 0.21
Attractively Valued IG Corporates -18.19 -17.92 -2.67 0.70 2.43 5.15 5.90 0.32
U.S. BBB Corporates -19.14 -19.03 -3.43 0.19 2.09 4.39 6.64 0.24
Attractively Valued BBB Corporates -19.69 -19.45 -2.55 1.15 3.24 6.41 6.87 0.4

Source: VanEck and Moody’s Analytics as of 9/30/2022. U.S. IG Corporates is represented by the ICE BofA US Corporate Index; U.S. BBB Corporates is represented by the ICE BofA BBB US Corporate Index; “Attractively Valued” refers to a strategy that selects the top 40% of bonds from each market based on a monthly basis at the end of each month.

Investing in the top 40% of bonds by excess spread each month, however, has practical difficulties in implementation. Because fair value can change rapidly based on market prices, the portfolio needs to be reconstituted frequently. Turnover would be excessively high, and trading costs could erode most or all of the excess returns generated by such a strategy. The VanEck IG Corporate Bond ETF (MIG) and VanEck BBB Corporate Bond ETF (MBBB) track indices that focus on the most attractively valued bonds based on their market spread relative to their fair value, based on metrics calculated by Moody’s Analytics. The indices include rules to limit turnover while still focusing on the most attractively valued bonds.

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Originally published by VanEck on 14 November 2022.

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DISCLOSURES

ICE BofA US Corporate Index (C0A0) tracks the performance of US dollar-denominated investment grade corporate debt publicly issued in the US domestic market.

ICE BofA BBB US Corporate Index is a subset of the C0A0 index that only tracks the AAA-rated corporate bonds.

This is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein. The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.

An investment in the VanEck Vectors Moody’s Analytics IG Corporate Bond ETF (MIG) and VanEck Vectors Moody’s Analytics BBB Corporate Bond ETF (MBBB ) may be subject to risks which include, among others, investing in European issuers, foreign securities, foreign currency, BBB-rated bond, credit, interest rate, liquidity, restricted securities, consumer staples sector, consumer discretionary sector, financials sector, energy sector, information technology sector, communication services sector, market, operational, high portfolio turnover, call, sampling, index tracking, authorized participant concentration, new fund, absence of prior active market, trading issues, passive management, data, non-diversified, concentration and trading, premium/discount and liquidity of fund shares risks. The Funds’ assets may be concentrated in a particular sector and may be subject to more risk than investments in a diverse group of sectors.

The Adviser has entered into a licensing agreement with Moody’s Analytics to use certain Moody’s Analytics credit risk models, data and trademarks. Moody’s Analytics® is a registered trademark of Moody’s Analytics, Inc. and/or its affiliates and is used under license.

The Fund is not sponsored, promoted, sold or supported in any manner by Moody’s Analytics nor does Moody’s Analytics offer any express or implicit guarantee or assurance either with regard to the results of using the Moody’s Analytics trademark or data at any time or in any other respect. Moody’s Analytics has no obligation to point out errors in the data to third parties including but not limited to investors and/or financial intermediaries of the Fund. The licensing of data or the Moody’s Analytics trademark for the purpose of use in connection with the Fund does not constitutes a recommendation by Moody’s Analytics to invest capital in the Fund nor does it in any way represent an assurance or opinion of Moody’s Analytics with regard to any investment in this financial instrument. Moody’s Analytics bears no liability with respect to the Fund or any security.

Investing involves substantial risk and high volatility, including possible loss of principal. Bonds and bond funds will decrease in value as interest rates rise. An investor should consider the investment objective, risks, charges and expenses of the Fund carefully before investing. To obtain a prospectus and summary prospectus, which contains this and other information, call 888.460.6805 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.

© Van Eck Securities Corporation, Distributor, a wholly owned subsidiary of Van Eck Associates Corporation.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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