The Case for Credit, Part 3: A History of Excess Returns

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Much of the renewed focus on fixed income this year rightly centers on the attractive level of nominal yields broadly across bond markets, given the U.S. Federal Reserve’s (Fed) hiking campaign of the past two years. Though investors are already pricing in easing across the term structure, the case for fixed income remains compelling. As the Fed prepares to pivot, investors are being compensated with unusually high, positive real yields, driven by the ongoing unwinding of quantitative easing and rapidly moderating inflation, among other factors. But we believe the weight of historical evidence suggests that investors can do better than Treasuries alone by employing a diversified approach to return-seeking credit.

Read on for the details, but in summary we find:

Corporate credit’s cumulative excess return over time makes a powerful statement for the benefits of this asset class compared to a U.S. Aggregate Index benchmark approach. And more credit exposure has historically been better: the median annualized excess return of high yield at 278 basis points (bps) dominates investment grade at 89 bps. Past performance is not an indicator or guarantee of future results.
The consistency of these benefits is also surprising. Over rolling five-year periods, non-Treasury fixed income has experienced positive excess returns close to 80% of the time.
Information ratios using excess returns similarly touts the benefits of credit. Specifically, high yield’s excess return information ratio relative to a duration-matched Treasury index exceeded that of the U.S. Aggregate Index relative to a duration-matched Treasury index 100% of the time on a rolling five-year basis, starting from late 2005—the first rolling five-year measurement period ended as of December 31, 2009—through 2023.

Why Consider Excess Returns?

Investors often focus on asset-specific benchmarks for credit markets, but less so on the performance of credit versus a duration-matched Treasury index alone. The latter approach simply strips out the tailwind of risk-free yields—Treasuries are considered risk-free securities—in generating total returns, as well as the performance impact of any ensuing moves in interest rates. This allows us to consider the merits of credit exposure on its own. Investors can then separately make distinct decisions on overall duration posture through portfolio rate overlays that are independent of the characteristic durations of preferred credit asset classes. As a reminder, portfolio overlays are additional investment vehicles or securities that are added to a portfolio to adjust a specific investment objective, such as interest-rate or currency exposure. In Figure 1, we start by tracking the long-term cumulative excess return of various fixed-income indices, including the generic fixed-income catch-all, the Bloomberg U.S. Aggregate Index.

Figure 1. Corporate Credit, and Particularly High Yield, Outperforms on a Long-Term Cumulative Excess Return Metric

Cumulative excess returns relative to duration-matched U.S. Treasury indexes, January 1, 1997-December 31, 2023

Source: Bloomberg. Data as of December 31, 2023. MBS=mortgage-backed security. IG=investment grade. Indices: MBS=Bloomberg MBS Index, U.S. Aggregate=Bloomberg U.S. Aggregate Index, High Yield Bond=Bloomberg U.S. High Yield Index, IG Corporate Bond=Bloomberg U.S. Corporate Index, High Yield BB-rated=Bloomberg U.S. BB High Yield Index, and High Yield B-rated=Bloomberg U.S. B High Yield Index. Treasuries are risk-free debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities are exempt from state and local taxes. Past performance is not a reliable indicator or guarantee of future results. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett.

While there are plenty of takeaways to note, perhaps most powerful is the lead that high yield corporates have enjoyed over higher-rated slices of fixed income. Additionally, within high yield, BB’s performance gap over B’s may initially strike as surprising, given the latter’s higher starting yields.

But this outperformance raises an important question for allocators: is credit’s long-term advantage due to several short periods of excellent performance, or is it consistent over time? In Figure 2, we present the annualized rolling five-year excess returns for the same indexes. Essentially, we are breaking down the cumulative performance of Figure 1 into five-year periods of time instead and displaying the annualized excess return over rolling periods.

Figure 2. Mapping Annualized Rolling Five-Year Cumulative Excess Returns; High Yield Holds Up Well

Annualized rolling five-year excess returns relative to duration-matched U.S. Treasury indexes, January 1, 2002-December 31, 2023

Here it’s clearer that there have been some periods of time when various credit asset classes have indeed underperformed a duration-matched Treasuries portfolio, most notably in and through the stressed environments of the “Tech Wreck” from the early 2000s and of course, the Great Financial Crisis (GFC). But as noted in the table in Figure 2, generally we see all forms of credit exposure outperforming Treasuries (i.e., positive excess returns) close to 80% of the time. Yes, agency MBS serving up positive annualized excess returns in 82% of rolling five-year periods edges out high yield at 79%, but just barely. But the median annualized excess returns of investment grade (89 bps) and high yield (278 bps) appear to be superior alternatives versus agency mortgages, or the U.S. Aggregate Index itself, with a similar proportion of positive excess return periods.

Corporate Credit’s Information Ratios Compare Favorably Too

Finally, we can compare information ratios across asset classes considering duration-matched indexes of Treasuries (matched to the duration of each asset class) as the benchmarks in the calculation. In Figure 3, we track the rolling five-year information ratio of annualized excess returns for investment grade, high yield, and the U.S. Aggregate Index. Clearly, the directional trends will mimic what we observed in Figure 2. But the benefit in this analysis is the ability to better capture how investors are being compensated for the underlying volatility of those excess returns by asset class.

Figure 3. High Yield’s Information Ratio Compares Well, Particularly Post-GFC

Rolling five-year Information ratio of annualized excess returns relative to duration-matched U.S. Treasury indexes, December 1, 2001−December 31, 2023

Source: Bloomberg. Data as of December 31, 2023. Information ratio is calculated by subtracting the return of a portfolio from the return of a benchmark and dividing the result by the tracking error of the portfolio to the benchmark. IG=investment grade. Indices: U.S. Aggregate=Bloomberg U.S. Aggregate Index, High Yield Bond=Bloomberg U.S. High Yield Index, and IG Corporate Bond=Bloomberg U.S. Corporate Index. Treasuries are risk-free debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities are exempt from state and local taxes. Past performance is not a reliable indicator or guarantee of future results. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett.

Again, high yield credit compares particularly well. Over the entire period shown, high yield’s information ratio exceeded that of the U.S. Aggregate Index 75% of the time. More notably, starting the measurement period post-GFC (which would include the five-year period ended as of December 31, 2009, as the starting point through December 31, 2023) shows high yield’s information ratio exceeding that of the U.S. Aggregate 100% of the time.

Summing Up

We believe the current nominal-yield environment will produce a fruitful set of opportunities for years to come. Treasuries may colloquially be considered risk-free assets. But our work here suggests that credit, and corporate credit in particular, can provide compelling portfolio benefits for investors over the long term—over shorter periods through time, as well as when adjusted for the volatility of those returns versus duration-matched Treasuries alone.

Past Performance of Selected Indices (calendar year):

NOTE: Return data expressed in percent and in U.S. dollars. Past performance is no indication or guarantee of future results. Source: Bloomberg. Data as of 31/12/2023.

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About the Author

Katie Cheung, CFA

Product Analytics Specialist

Katie Cheung is responsible for developing high-impact thought leadership, capital markets and product-related content for each market we serve based on data-driven investment theses and clearly articulated client applications.

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Glossary & Index Definitions

Bloomberg U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis.

Bloomberg High Yield Bond Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moodys, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.

Bloomberg U.S. Corporate Index covers publicly issued, investment-grade U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered.

Bloomberg High Yield BB-rated Index is the BB-rated component of the Bloomberg High Yield Bond Index.

Bloomberg High Yield B-rated Index is the B-rated component of the Bloomberg High Yield Bond Index.

Bloomberg MBS Index covers the mortgage-backed pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The MBS Index is formed by grouping the universe of over 600,000 individual fixed rate MBS pools into approximately 3,500 generic aggregates.

Quantitative easing refers to a monetary policy action where a central bank purchases predetermined amounts of government bonds or other financial securities/assets in order to stimulate economic activity.

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Excess returns are the return achieved by a security (or portfolio of securities) above the return of a benchmark. The risk-free rate (i.e., Treasuries) and benchmarks with similar levels of risk to the investment being analyzed are commonly used in calculating excess returns.

Real yield is the stated yield on a fixed-income investment minus the impact from inflation.

Information Ratio measures and compares the active return of an investment compared to a benchmark index relative to the volatility of the active return.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

A basis point is one one-hundredth of a percentage point.

The Federal Reserve (Fed) is the central bank of the United States. The federal funds (fed funds) rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight.

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