• In 2022, credit spreads were positively correlated with rising government bond yields—resulting in heavy losses for credit investors.  This year, the relationship has shifted; as government bond yields have risen, credit spreads have tightened.
• Bond yields are at much higher levels than two years ago, providing sufficient income to help cushion investors against any near-term volatility.
• Assuming economic conditions remain stable, we expect credit spreads to move within a narrower range than in recent years - which should allow corporate bonds to continue to perform well.

When inflationary fears caused central banks to hike interest rates in 2022, corporate bond investors faced a double whammy of rising government bond yields and widening credit spreads.

With government bond yields on the rise this year, it’s raised concerns that we could see a repeat of 2022 - when double-digit declines in credit markets took many investors by surprise. Yet the situation today is quite different from two years ago, and the shift in market dynamics could provide an ideal environment for active credit outperformance. 

Decomposing the drivers of credit returns

To understand how things have changed in credit markets, it’s important to understand the drivers of corporate bond returns. The yield on a typical investment-grade corporate bond has two components: the portion relating to the yield on a comparable government bond, and the credit spread. The credit spread represents the risk premium an investor receives for the credit risk portion of a corporate bond.

When high inflation led central banks to hike interest rates in 2022, government bond yields started rising steadily. At the same time, credit spreads widened, amid fears that rising rates would cause a spike in defaults and delinquencies among corporate bond issuers due to higher financing costs.

The anticipation of further rate hikes drove government bond yields higher and pushed credit spreads wider—resulting in heavy losses for government bond and credit investors in 2022, as illustrated in the chart below.

The relationship between credit spreads and government bond yields has shifted

Monthly cumulative returns for government bonds and monthly cumulative excess returns for credit, 2022-present

Notes: Cumulative excess return represents the credit-spread-related portion of the total return of the Bloomberg Global Aggregate Corporate Index.  The cumulative government bond return represents the total return less the excess return of the Index. The government bond yield is the yield of the Index less the Index’s option-adjusted spread (OAS). Returns are cumulative and include reinvestment of all income, net of fees, for the period 31 December 2021 to 31 March 2024. Returns are hedged to USD. Source: Bloomberg, using Vanguard calculations. 

A shift in the yield-spread correlation

Fast forward to 2024, and government bond yields, which had been pricing in several rate cuts this year, have been steadily rising once more—fuelled (again) by higher-than-expected inflation that riled markets to pare back their rate-cutting expectations for the year.

Yet the strong positive correlation between government bond yields and credit spreads that drove down credit returns in 2022 is missing in today’s market; instead, credit spreads, which were already tight coming into 2024, have tightened further while government bond yields have climbed higher (see the chart above). The shift is broadly due to a more supportive and stable economic backdrop compared with two years ago.

That’s good news for credit investors, in our view. Assuming economic conditions remain stable, we expect credit spreads to move within a narrower range than in recent years - which should allow corporate bonds to continue performing well, in total return terms, in spite of recent market turbulence.

There are a number of reasons why we think credit will continue to perform in the current market environment: 

Given this backdrop, active credit funds that focus on bottom-up security selection and have the credit research capabilities to identify undervalued and mispriced opportunities, have a distinct edge over those with a more top-down, directional approach. A selection-centric strategy can also help to preserve the risk-dampening qualities of bonds—giving investors what they expect from the fixed income asset class—high-quality, investment-grade holdings that should act as a diversifier relative to equities through varying market conditions.

¹ Source: Bloomberg, as at 29 December 2021.  

² Source: Bloomberg, as at 24 April 2024.

³ Source: Bloomberg and Vanguard. Average investment-grade credit spreads are based on the option-adjusted spread of the Bloomberg Global Aggregate Corporate Index, for the periods 1 January 2004 to 1 January 2007 and 1 January 2024 to 31 March 2024. Excess returns are based on the period 1 January 2004 to 1 January 2007.