Typically you'd expect higher-risk assets to generate higher returns. But when it comes to high-yield corporate bonds, indiscriminate exposure to the CCC-and-below category may not produce the expected results.
Typically you’d expect higher-risk assets to generate higher returns. But when it comes to high-yield corporate bonds, indiscriminate exposure to the CCC-and-below category may not produce the expected results.
Bonds rated CCC and below can be fertile ground for active managers. They have a wide distribution of returns, so there can be rich rewards for identifying winners and avoiding losers.
Additionally, pricing anomalies are relatively common.
For, example at times of high anxiety, markets sometimes price in excessively pessimistic assumptions about bankruptcy rates.
With strong research and security selection, nimble investors should be able to find attractive buying opportunities in all but the worst market scenarios.
But the lowest-rated bonds are not for everyone.
Growing numbers of investors want yield, but they are nervous about volatility and want to reduce the risk of extreme outcomes.
So, what would be the impact of entirely excluding lower-rated credit from the opportunity set?
In terms of diversification, the impact is modest. Only about 12% of the global high-yield corporate market is rated CCC and below, so such a strategy doesn’t meaningfully restrict the choice.
What about missing out on the upside?
CCC bonds are often among the star performers in a credit rally. Today, we don’t think this is an immediate concern. For a major rally to occur, credit spreads first have to build up to a peak. The most recent peak was November 2008, at the height of the financial crisis, with the Barclays Capital Global High Yield Index reaching spreads of about 17%. Today, we are near long-term average spreads-around 6% at the end of July.
We think it’s more likely that we’ll continue on in a volatile market with mini-peaks and mini-rallies.
In our view, higher-quality names are very well suited to this environment-particularly for investors who want to limit their exposure. Should a large sell-off take place, we’d expect higher-rated assets to be more resilient than more aggressive high-yield holdings.
In a study on the US credit market from January 1993 to June 2011, comparing the performance of the different categories of high-yield credit, we found that the highest-rated segment (BB) captured 88% of the upside in rising markets, compared with only 68% of the downside when markets were falling.
This pattern of capturing more upside than downside resulted in overall returns that were both higher than the overall market and less volatile.
CCC bonds actually performed the worst, returning an average of about 6% per year – almost 3% less than BB rated bonds.
In other words, on average, the least risky bonds performed best. To get an idea of why lower-risk assets tended to outperform, we divided the data into four market-cycle phases, shown in the display below.
CCC bonds as a group did extremely well in ‘rally’ phases – averaging double the returns of BB- and B-rated bonds.