Rethink your approach to corporate credit

investment viewpoints

Rethink your approach to corporate credit

Leslie Sita - Client Portfolio Manager

Leslie Sita

Client Portfolio Manager

Leslie Sita, Client Portfolio Manager, discusses how a cautious move lower in credit ratings could enhance fixed income returns for only a moderate increase in risk.

 

What are crossover bonds? How might they help fixed income investors improve their returns without taking on excessive risk?

Crossover bonds are corporate bonds rated BBB and BB. This segment presents a compelling risk-return profile, we believe.  With yields being historically low and no interest rate rises on the horizon, we expect investors will continue to search for yield. But traditional, investment grade corporate bonds have become less attractive in the low yield environment, and face increased risk from duration.  We believe corporate bond investors should instead move cautiously down the credit ratings spectrum into the crossover area in order to enhance returns for only a moderate increase in risk. 

 

What sort of performance has crossover provided in the past?

Crossover bonds have typically provided a higher return potential than investment grade portfolios in the US and Europe.  Average yields for crossover issuers were more than 50bps higher than those of investment grade issuers at the end of February 20191, for instance.

Credit spread returns2 for investors have also proved superior in the past.  As investors move down the ratings spectrum, the general trend is for an increase in credit spread returns to reward increased credit risk. However, counter-intuitively, BB-rated issuers in the past have offered higher returns than issuers with lower ratings in the B segment3.  

 

That does sound counter-intuitive.  Why have such BB-rated bonds outperformed lower-rated bonds?

BB-rated issuers tend to outperform because they include so-called fallen angels.  Fallen angels are borrowers that have been downgraded below investment grade.  Yet fallen angels have outperformed other BB-rated borrowers, as well as B-rated issuers, in the past4 because of certain market dynamics. 

Essentially, when fallen angels are downgraded, they spark forced selling by investors who are required to maintain investment grade rated holdings. These sellers meet inadequate demand, however, therefore causing a shock to prices.  Over time, the shock typically subsides, but when the downgrade occurs, it means that bonds issued by fallen angels offer higher returns than neighbouring bonds – even lower-rated ones5

This is what we refer to as the credit sweet spot for crossover, as the performance of fallen angels partly explains why crossover bonds feature improved returns.

 

What about the increased risks? 

Investors in corporate credit should always take into account their exposure to the credit risk of a bond issuer.  Indeed, the crossover segment does increase credit risk relative to investment grade and there have been concerns about an increase in corporate leverage since the 2008 global financial crisis.  But we highlight several arguments in favour of the crossover segment.

For instance, the credit quality of the overall investment grade universe has been declining since the financial crisis, whereas the average rating of the crossover index has been stable at BBB6.

In addition, the fundamental credit quality of crossover issuers also appears relatively robust relative to other ratings segments.  Over the past three decades, the rating of lower-rated investment grade (BBB-) and BB+ issuers appears to improve over time - the opposite is true for all other rating buckets7.

Default characteristics are beneficial for crossover issuers, as well. The probability of a borrower not repaying its debt typically increases as credit ratings fall.  But the historical probability of BBB-BB rated borrowers defaulting is only marginally above that of the higher-rated, A to BBB segment. Default probability is also much lower than borrowers rated B or lower in so-called high yield8.

Another very important point is drawdowns of the crossover segment are similar to those of investment grade bonds9.

Overall, crossover captures the best aspects of investment grade and high yield universes, in our opinion.

 

How do you approach investing in crossover? How is sustainability involved?

We believe implementation is paramount to managing credit risk without compromising returns.  At every step, our approach prioritises the quality of the debt in the portfolio in order to better buffer investors.  This contrasts with a market-cap approach that focuses on the quantity of debt issued by a borrower and tends to over-weight the most indebted issuers without taking into account their underlying credit fundamentals.

We build portfolios based on a systematic approach, and then use a fundamental, discretionary analysis - both incorporate sustainability as a key factor.  At the systematic level, we specify sectors with a high contribution to the economy, attractive credit spreads and good liquidity. Sectors that are less carbon-intensive will have an increased weight.  We also orient our allocation to favouring issuers with strong fundamental credit quality, and prioritise issuers with sustainable business practices (ESG and carbon intensity) and a willingness to issue climate bonds, for example.  

At the discretionary level, we look to further mitigate the portfolio’s default risk exposure by continually monitoring issuer credit risk through a team of specialised analysts and portfolio managers. These specialists have the risk budget to intervene in order to protect the portfolio, and provide an uncorrelated source of returns.

We believe our sustainable approach can generate a robust crossover portfolio that delivers higher risk-adjusted returns over time, and is well-adapted to the current environment.

 

Please find key terms in the glossary.

 

sources.

1 Source: Barclays POINT, Bloomberg Barclays Indices: Euro Credit Corp and US Credit Corp, LOIM calculations as at 28 February 2019. Past performance is not a guarantee of future results. Yields are subject to change and can vary over time. For illustrative purposes only.
2 Credit spread returns account for losses from downgrades or defaults, which may be especially significant for lower rated portfolios.
3 Source: Barclays POINT, Bloomberg Barclays Indices: Euro Credit Corp and US Credit Corp, LOIM calculations. Past performance is not a guarantee of future results. Yields are subject to change and can vary over time. For illustrative purposes only.
4 Average credit spread returns from October 2004-February 2019.  Source: Barclays POINT, Bloomberg Barclays Indices: Euro Credit Corp and US Credit Corp, LOIM calculations.  Yields are subject to change.  Past performance is not a guarantee of future results.
5 Based on BB credit spread returns vs B credit spread returns 2004-2019 in USD and EUR. Source: Barclays POINT, Bloomberg Barclays Indices: Euro Credit Corp and US Credit Corp, LOIM calculations.  Yields are subject to change.  Past performance is not a guarantee of future results.
6 Average rating of crossover vs investment grade issuers from January 2008-February 2019.  Source: Barclays POINT, Bloomberg Barclays Indices: Investment grade universe (Euro Credit Corp; US Credit Corp) and crossover universe (composite index of Euro Credit Corp BBB & Euro High Yield BB; composite index of US Credit Corp BBB & US High Yield BB), LOIM calculations. Past performance is not a guarantee of future results.
7 Measured by average annual upgrade rate less downgrade rate by rating bucket as reported by Moody’s. 1983-2017. Source: LOIM calculations. Moody’s Annual Default Study: Corporate Default and Recovery Rates, 1920-2017.  Past performance is not a guarantee of future results.
8 Default probability according to credit rating (1996-2014). Source: S&P Annual Corporate Default Study, 2014. LOIM calculations. Past performance is not a guarantee of future results.
9 Source: Barclays POINT, Bloomberg Barclays Indices, LOIM calculations. Reference period October 2004 to February 2019 in USD and EUR.  Past performance is not a guarantee of future results.

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