Flash Update - US Investment grade market: Look for a moderate duration

Olivier Debat, Senior Investment Specialist Union Bancaire Privée, UBP SA

Investors holding exposures to the US investment-grade market found themselves caught in the interest rate sell-off that has been seen so far this year. Although the US investment-grade market is made of quality credit, as opposed to more leveraged high-yield issuers, it bears significant interest exposure. For instance, it stands at 7.9 years for the Bloomberg US Corporate Bond index. As interest rates moved sharply higher, allocations to the US investment-grade segment returned a disappointing -11.5%.

This highlights the risk of 1) passive investment when it comes credit and 2) long-dated investments in the credit space. Regarding the latter, this shows that investors are not compensated for the maturity risk they are taking. A more moderate average maturity of 4–5 years has a more balanced risk/reward profile and has outperformed the broader market +by 5.6% so far this year. The UBAM - Medium Term US Corporate Bond is positioned on this market segment.

Figure 1: Relative outperformance of 4-year bonds vs. 8-year bonds since the beginning of the year

2 ubp relative outperformance of 4 year bonds vs. 8 year bonds since the beginning of the year 1

Source: UBP, Bloomberg Finance L.P. as of 24 May 2022. 4-year bonds represented by the UBAM - Medium Term US Corporate Bond (IC USD share class net of fees). 8-year bonds represented by the Bloomberg US Corporate Bond Index (ticker : LUACTRUU Index). Past performance is not a guide to current or future returns.

In addition, for one unit of risk, a standard 8-year exposure has 0.7% of carry and roll-down. This compares with 0.9% for a 4-year exposure, i.e. +30% more reward for -40% less duration risk. In other words, Investors in a 8-year bond portfolio are not compensated for the maturity risk they are taking. Historically, a moderate allocation to credit had similar returns to a longer allocation with less volatility and less drawdown in crises as illustrated in the table below. The main reason behind this is that credit and rate curves are almost flat – if not inverted – on the longer maturities and thus offer no yield pick-up for holding those longer-dated bonds.

Figure 2: Comparison of risk/return profile for 4-year bonds vs. 8-year bonds in %

2 ubp comparison of risk return profile for 4 year bonds vs. 8 year bonds in 2

Source: UBP, Bloomberg Finance L.P. as of 18 May 2022. 4-year bonds represented by the ICE BofA US Corporate index (ticker: C5A0). 8-year bonds represented by the ICE BofA US Corporate index (ticker: C5A0). Past performance is not a guide to current or future returns.

Currently, the market is pricing in a terminal rate for the Fed at 3% and 5-year US Treasuries are trading at 2.7%. Thus, the risk/reward of an allocation to credit with moderate maturity is looking increasingly appealing and suggests investors could start building positions.

Figure 3: 5-year US Treasury rates vs. the market’s pricing in of the Fed terminal rate in %

2 ubp 5 year us treasury rates vs. the market%e2%80%99s pricing in of the fed terminal rate in 3

Source: UBP, Bloomberg Finance L.P. as of 24 May 2022. Past performance is not a guide to current or future returns.

UBAM - Medium Term US Corporate Bond has a moderate interest rate exposure of around four years on average. The interest rate exposure is actively managed and our cautious view on rates has generated 1% of alpha so far this year (end of April). The fund has outperformed its benchmark 9 times during the last 12 years. It should be the instrument of choice for investors looking to gradually add exposure to the segment.