Downgrades and defaults can detract from corporate bond portfolio performance. Let’s look at how applying fundamental credit research may help reduce these risks.
The economic recovery and subsequent earnings growth since the height of the pandemic five years ago helped investment grade (IG) corporations build healthy balance sheets, causing credit spreads to tighten toward the lower end of their historical range. But spreads have widened recently on growing concerns that economic and policy uncertainty may lead to a slowdown, accelerating credit downgrades. Should this occur, fundamental research may have the potential to provide an important layer of risk mitigation.
Avoiding idiosyncratic loss is a key driver of an IG corporate bond portfolio’s total return and income. These losses occur when a security defaults or when the ratings agencies downgrade a security from IG to high yield (HY). While IG bond defaults are infrequent, downgrades from IG to HY are not. Holding these downgraded bonds—known as fallen angels—has historically detracted significantly from performance.
What do credit spreads tell us?
Credit spread is the additional yield that investors require to purchase a corporate bond rather than a comparable duration US Treasury security. The extra yield compensates the investor for taking default and downgrade risk. In general, credit spreads are influenced by the level of economic activity:
- Spreads tend to narrow during periods of strong or stable growth when the economic outlook is good, and downgrades and defaults are less likely.
- Narrow credit spreads imply that the risk of default or downgrade is low.
- Spreads tend to widen during periods of weak growth, recession or economic uncertainty as the risk of downgrades and defaults increases.
- Wide credit spreads imply a higher level of risk.
Historically, IG investors have been rewarded for taking credit risk. From the end of December 1996 through March 2025, the ICE BofA US Corporate Index produced an annualized total return of 5.1%, inclusive of all losses from credit events like defaults and downgrades. Over the same period, when measured against the comparable duration Treasury security, IG corporates generated nearly double the cumulative return, or an excess return of 0.94% per year. During this 29-year period, there have been three serious recessions—notably, the Great Recession of 2008—with their attendant increases in downgrades and defaults. Focusing on the past five years, the US corporate index’s annual total return was 1.8%, producing an excess return of 4.10% above Treasurys. Over these periods, we would argue that taking credit risk has been a good proposition.
When viewed through a historical lens, the amount of compensation investors currently receive for taking credit risk is near the middle of its long-term range. Spreads ended March at 97 basis points (bps) after hitting a low of 79 bps during the quarter—within 2 bps of their lowest level in 25 years. During April, spreads continued to widen to 120 bps on concerns about the level of tariffs and their ultimate impact on economic growth. While we expect defaults and downgrades to remain tolerable, uncertainty is clearly rising.
Why should we avoid fallen angels?
Ratings agencies constantly reevaluate where an issuer belongs in the credit spectrum. The best issuers—those rated AAA, AA, A and BBB—are classified as investment grade, and those with ratings of BB, B and CCC as high yield.
Fallen angels are companies that have lost their IG rating due to a downgrade, and their bonds now reside in the HY universe.
When a security falls from IG to HY, its yield rises and its price falls sharply—due not only to the increased risk of default, but also to forced selling when investment guidelines require managers to sell issues that lose their IG rating. This forced selling can push bond prices significantly below fair value. It’s notable that the market has tended to reprice risk much more quickly than the ratings agencies have changed ratings. By the time the ratings agencies have downgraded an issuer, most of the damage has already occurred.
Spreads have widened by an average 245 bps in the three months prior to the downgrade, contributing to an average loss on a fallen angel of 13% from 1987 to 2020. During the worst period, from 2002 to 2012, this average loss increased to 24%. Obviously, incurring losses of this magnitude would be a material drag on a bond portfolio’s performance.
Solutions for today’s complex interest rate environments
Why fundamental credit research matters
Some managers, including Parametric, use fundamental research to help them avoid owning deteriorating credits in their semi-passive ladder and index replication strategies. To achieve this goal, we believe a credit team should apply the same forecasting skills that they’ve developed to identify value in the IG universe for their active strategies. Analysts use a variety of techniques to evaluate issuers:
- Ongoing conversations with ratings agencies, management teams and other industry sources help develop fundamental views for both single issuers and sectors.
- Earnings and cash flow models provide insight into company dynamics and prospects.
Of course, as with other areas of investment research, there is no substitute for experience.
How Parametric seeks to avoid downside rating migration
When investors are concerned about downside risk, we find that having the right culture and processes in place can contribute to the success of a strategy that seeks to preserve principal. Since it’s rare that a company defaults while its bonds carry an IG rating, we think credit analysts should focus their research on assessing downgrade risk to determine that company’s principal protection rating—on a scale separate from its active rating. In our view, only issuers that have been reviewed and approved by research should be considered for inclusion in an actively managed corporate bond portfolio.
A main objective of every Parametric corporate bond strategy is mitigation against downside credit rating migration through proper industry diversification and prudent issuer selection.
- Fundamental research seeks to help minimize idiosyncratic risk by selecting issuers whose industry fundamentals, management strategy and financial metrics may tend to result in stable credit ratings, no matter the economic environment.
- Quantitative methods may provide a scalable way to monitor and manage systematic risk across accounts.
During the last five years, 53 corporate bond issuers have fallen from IG to HY. Through our research, Parametric’s IG analyst team was able to identify them all as downgrade risks. We believe our approach has helped us to limit losses associated with fallen angels and other credit events.
Read our strategy overview to learn more about Parametric Managed Corporate Portfolios.
The bottom line
- All-in corporate yields near the highest levels available since 2009 had generated robust demand for the asset class and kept spreads at the lower end of their historical range—reducing the margin for error.
- Economic and policy concerns have caused spreads to widen recently; if the economy goes into recession, IG corporate bond spreads would be likely to rise and credit downgrades to increase.
- In our view, bond portfolios that employ fundamental research to help preserve principal could be well positioned to navigate a period of higher risk and volatility.
Parametric’s Laddered Interest Rate Scenario Tool helps investors explore the performance of corporate bond portfolios in changing rate environments.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.
04.21.2026 | RO 4413514
