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  • Income Investing

    Finding an Investment Grade Edge

    William Sokol, Senior ETF Product Manager
    May 18, 2021
     

    Corporate bond investors are faced with a challenge in the current environment: sacrifice income or take more risk. Over the past decade, corporate leverage (measured by debt to EBITDA, or earnings before interest, taxes, depreciation and amortization) has increased, particularly in the past year.The portion of the market comprising BBB-rated bonds, the lowest rating within investment grade, increased by nearly $3 trillion and now comprises over 50% of the broad market.Over the same period, credit spreads have steadily grinded tighter. While there are many factors behind this, the fact remains that an investor with broad corporate bond market exposure is earning less compensation while taking higher credit risk.

    We believe that being selective is critical in this environment. Despite today’s tighter spread and overall yield levels, corporate bonds remain a crucial component of an overall bond allocation because of the additional spread over U.S. Treasuries they provide. This can increase the overall yield of a core income portfolio without an investor having to go too far down the credit spectrum, assume additional liquidity risk or add volatility. A smarter approach to corporate bonds can provide investors with the benefit of yield pickup and upside potential without having to assume too much risk. But what approach can investors take to achieve better outcomes?

    Deviating from a broad market exposure can take various forms, and some broad categories of investment approaches are listed below.

    Approaches to Investing in Corporate Bonds

    A quality oriented approach can be appealing in some environments, particularly in deteriorating credit environments and when market volatility is high, by avoiding bonds which may decline in value—for example, bonds at high risk of downgrade. Such an approach has historically worked in the high yield market over the long-term. However, within investment grade, where the absolute risk of loss from defaults is historically low, this can mean sacrificing substantial yield for a benefit that may not consistently outweigh the cost. Alternatively, a “yield enhanced” approach, which selects the highest yielding bonds, may increase yield potential, but not without substantial risk. In general, higher yields should reflect higher risk, and given that there is generally more downside than upside in bonds, the margin for error may be slim. A naive strategy that simply selects the highest yielding bonds, even if controlling for other risk factors such as duration, can introduce significant downside risk and result in underperformance.

    We believe a strategy that focuses on valuation can be particularly effective in the investment grade market. In other words, identifying bonds that provide high compensation relative to the level of risk assumed. Rather than focusing on absolute yield or spread levels, such an approach focuses on relative value and identifying mispricings where investors can capture additional spread over the “fair value” spread justified by the underlying risk of the bond. The key is to accurately evaluate forward-looking risk and value in order to compare against market prices. Our preferred approach uses proprietary credit metrics developed by Moody’s Analytics to identify attractively valued bonds. Moody’s Analytics is the industry leader in credit risk modelling, and hundreds of the world’s largest institutions rely on their credit model for risk management and portfolio management decision making. More information on the Moody’s Analytics credit model can be found here: Smarter Approaches to Corporate Credit.

    Using the Moody’s Analytics credit model, the broad investment grade market can be parsed to identify and select bonds which are attractively valued (where market spreads exceed fair value) and avoid bonds which appear to be overpriced (where market spreads are less than fair value) and which may introduce downside risk to a portfolio.

    Deviation from Fair Value Creates Opportunity in Investment Grade Bond Universe

    Deviation from Fair Value Creates Opportunity in Investment Grade Bond Universe

    Source: Moody’s Analytics, ICE Data Indices and VanEck, as of 3/31/2021

    A broad market strategy which does not screen holdings based on valuation holds bonds will, by nature, have substantial exposure to bonds with “negative excess spread.” In fact, the broad investment grade market currently exhibits a negative excess spread, on average, meaning that investors are not earning adequate compensation for the risk they are assuming. The same is true for a “yield enhanced” strategy which only considers yield levels without regards to risk.3

    A portfolio of attractively valued bonds allows investors to potentially earn an attractive yield in their core fixed income portfolio without taking excessive risk. Overall yield is not sacrificed through this approach, and generally investors have benefitted from a greater income return from attractively valued bonds versus a broad market exposure. In addition, these bonds have significant positive excess spread, which provides upside potential as market prices potentially converge towards fair value over time.

    The VanEck Vectors Moody’s Analytics IG Corporate Bond ETF (MIG) seeks to track, as closely as possible, before fees and expenses, the price and yield performance of the MVIS® Moody’s Analytics® US Investment Grade Corporate Bond Index, which includes investment grade corporate bonds that have attractive valuations and a lower probability of being downgraded to high yield compared to other investment grade bonds. VanEck Vectors Moody’s Analytics BBB Corporate Bond ETF (MBBB) focuses on the BBB rated segment of the market and seeks to track, as closely as possible, before fees and expenses, the price and yield performance of the MVIS® Moody’s Analytics® US BBB Corporate Bond Index.

    DISCLOSURES

    Source: BofA Global Research.

    Source: ICE Data Indices as of 4/30/2021. Size of BBB market compares BBB portion of the ICE BofA US Corporate Index from 4/30/2011 compared to 4/30/2021.

    Source: Moody’s Analytics, ICE Data Indices and VanEck as of 4/30/2021. Broad investment grade market is represented by the ICE BofA US Corporate Index. “Yield enhanced” strategy is represented by segmenting the ICE BofA US Corporate Index into five duration buckets (1-3, 3-5, 5-7, 7-10 and 10+) and selecting bonds within each duration bucket that are in the highest decile by yield to worst.

    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, financials sector, energy 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.

  • Authored by

    William Sokol
    Senior ETF Product Manager

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