Pictet Asset Management.
For many investors, government bonds are the bedrock of safety, while equities symbolize growth and opportunity. Credit, particularly Investment Grade and High Yield, is often seen as a riskier middle ground. Yet, over the past two decades, credit has consistently offered a superior risk-reward profile compared to both government debt and equities, making it an underappreciated cornerstone of strategic asset allocation.
A historical analysis from 2001 to 2023 shows that European Investment Grade credit outperformed German government bonds with similar volatility but higher returns, yielding a significantly better Sharpe ratio. High Yield credit, often considered risky due to default concerns, also outperformed European equities on a risk-adjusted basis. Notably, equities delivered higher volatility, deeper drawdowns, and poorer compensation for the risks taken.
When combined, Investment Grade and High Yield credit formed a more efficient portfolio than the traditional mix of government bonds and equities. Across different interest rate environments—whether tightening or easing—credit portfolios offered better returns with lower volatility. Even under rising rate regimes, credit outperformed, debunking the myth that fixed income underperforms when rates climb.
Default risk, especially in High Yield, is a frequent concern. However, the data shows that credit spreads—premiums offered to compensate for credit risk—more than make up for potential losses. For instance, B-rated bonds had a 0.94% annual default rate from 2001 to 2023, yet they still generated an average annual excess return of 3.4% versus government debt. Moreover, recovery rates for defaulted bonds averaged around 40%, limiting losses further. By comparison, equity investors face a complete loss in bankruptcy scenarios.
Importantly, credit markets are less reliant on timing. Thanks to the pull-to-par effect—where bond prices converge to face value at maturity—and steady coupon payments, drawdowns in credit tend to be temporary and recover faster than those in equities. Following major downturns, European High Yield markets historically rebounded strongly within 18 months, often fully recovering initial losses. This is in stark contrast to equities, which can take much longer to bounce back.
Credit’s performance also remains resilient across macroeconomic cycles. In low growth environments, credit—especially Investment Grade—consistently outperformed equities. During high inflation periods, credit’s performance aligned with or exceeded equities, highlighting its robustness.
Beyond traditional yield collection, credit offers multiple sources of return. These include primary market premiums, liquidity premiums, roll-down on upward-sloping credit curves, convexity benefits, and optionality in callable bonds. These technical nuances create alpha opportunities for skilled investors.
In conclusion, credit should no longer be relegated to a peripheral role in portfolio construction. Its combination of resilience, risk-adjusted returns, and structural richness makes it an essential asset class. A balanced allocation to both Investment Grade and High Yield credit enhances portfolio efficiency and provides long-term benefits. For investors focused on stability and steady growth, credit is not just complementary—it is foundational.
