With spreads well below long term averages and government bond curves pricing in what central banks are likely to do in the next few quarters, opportunities for capital gains through spread compression or sustained rallies in government bonds appear to be limited. In our view, one of the effective avenues through which total returns can be enhanced in this environment without unduly increasing default risk, is to take advantage of the shape of the curve.
There are two ways in which one could increase the credit exposure of a portfolio, beyond increasing the allocation to credit vis-á-vis government bonds. The first is to take the average rating down. The same percentage allocation to credit but a lower average rating, increases the yield, all else being equal, at the expense of increasing, at least in theory, the risk of default and volatility. Given the spread compression between rating bands, we believe this approach offers a poor risk reward trade off.
A second alternative is to increase credit spread duration. This means, in essence, extending the duration of the credit one already holds. In this scenario, the credit risk, measured as default risk, does not increase. However, the portfolio’s sensitivity to moves in spreads does increase as the average portfolio holding is longer dated. If the risk of holding bonds that are more sensitive to changes in spread is accompanied by a decent boost in yield, this might be a risk worth taking. When curves are flat, you do not get more yield for going longer out the maturity curve. Currently, however, in selective markets, there is a reasonable steepness that we can take advantage of, both in government bond curves and in credit spreads.
Starting with government bond curves, the most emblematic case is the Euro curve. In the first days of January last year, the yield of 2-year Bund was practically the same as a 6-year Bund. Investors gained no additional yield for extending four years. Of course, it could be argued that locking in those yields for longer was still a reasonable move, but it goes without saying that the trade would have been significantly more attractive if yields at the 6-year point in the curve were higher than at the 2-year point. Now however, the 6-year yield is 2.5% while the 2-year yield is just under 2.10%.
If we look at what spreads we can get for different tenures, the picture is also favourable. Taking the Xover CDS index, which represents European high yield spreads, we can see in the graphs below that the difference between a 5-year spread and a 3-year spread, was circa 50 basis points (bps) a year ago. That difference is now close to 75 bps. In an analogous manner, the difference between a 7-year and a 3-year spread was about 85 bps in January 2025, now it has widened to just under 120 bps. Clearly, there is a healthy increase in yields both from bunds and from spreads for extending credit spread duration. For credit that we like we believe it is a risk that has a reasonable reward and is worth considering.
Finally, it is worth mentioning that steeper curves also allow for capturing small capital gains through rolling down the curve. When curves are flat, the fact that a year goes by has minimal effect on the price movement of a plain vanilla bond, as cash flows are discounted at the same rate. When curves are steep, as a bond moves from being a 5-year bond to a 4-year bond, the yield at which those cash flows are discounted is lower. Therefore, a capital gain is accrued.
In a world where spreads are tight and government bond curves are pricing in what central banks are likely to do, taking advantage of the steepness of the curve allows for adding extra returns to the starting yield without unduly increasing default risk. This is not a free lunch. Mark-to-market volatility will increase if we sell 3-year bonds to buy 5-year or 7-year equivalents, but the reward for that risk in higher quality credits looks compelling to us, on a bond by bond basis.
