Crossover as a credit complement: a risk-return  profile

investment viewpoints

Crossover as a credit complement: a risk-return profile

Ritesh Bamania - Head of UK and Ireland Institutional Clients and Solutions

Ritesh Bamania

Head of UK and Ireland Institutional Clients and Solutions
Anando Maitra, CFA - Head of Systematic Research

Anando Maitra, CFA

Head of Systematic Research
Leslie Sita - Client Portfolio Manager

Leslie Sita

Client Portfolio Manager

Fixed income investors seeking increased returns for only a moderate move lower in credit ratings could find interesting opportunities in an area of corporate bonds called crossover.  Crossover bonds are corporate bonds that span credit ratings from the lowest-calibre of investment grade to the highest-calibre of high yield.  This market segment, rated between BBB and BB, is prevalent globally across regions and currencies, with a deep universe of bond issuance1

The crossover space could be an attractive solution for investors looking to lock in improved returns in relation to investment grade, while avoiding the more pronounced credit risk of lower-rated high yield.  Tapping into what is sometimes referred to as a credit rating ‘sweet spot,’ a crossover strategy  may boost returns relative to traditional investment grade strategies2, yet present a moderate credit risk profile that has lower default probability and drawdowns than high yield3.

How can this ‘sweet spot’ be created? The greater return potential for investors can be explained by the inclusion of fallen angels in the BB universe on the one hand, and the propensity for improved fundamentals on the other.  Fallen angels are recently-downgraded issuers that, due to a valuation shock at the time of downgrade, have tended to fuel the BB-rated bucket yielding relatively more than lower ratings buckets in B space4.

Secondly, a tendency for improved fundamentals means a crossover strategy may also provide higher returns over time.  In the past, crossover issuers have tended to behave in a credit-positive manner, demonstrating a greater scope for enhanced ratings5. This behaviour could further drive the yield enhancement afforded by crossover issuers and means investors can be disproportionately rewarded for only a relatively small move down the credit spectrum6.

Turning to the risk characteristics of the strategy, a crossover approach can be situated between investment grade and high yield.  In the past, a crossover approach has shown lower default probability than a high yield strategy, and default probability that is closer to rates seen in IG.  Historically, crossover credits have a lower cumulative default probability than credits rated below the BB bucket7.  The default probability of crossover is closer to rates seen in investment grade than to rates in B or below – indeed, default probability begins to rise significantly below the BB credits.  A crossover approach also has more positive drawdown characteristics that are similar to those of IG and lower than those of high yield8. These risk characteristics lead to crossover having a moderate credit risk profile that is more aligned with investment grade.

Taking these risk and return characteristics into account, we suggest complementing a credit, or buy and maintain strategy, with crossover in order to diversify exposure.  Traditional credit strategies have tended to invest in investment grade credit, with the largest portion in A-rated names, and some investment in the higher-quality BBB area.  Two popular ways to increase spread have been to barbell investment grade with high yield, or to move into secure, income-type illiquid asset classes, such as property or infrastructure9.

The crossover strategy provides another option to improve yield for moderate credit risk by effectively bulleting into BBB to BB space, and could be used together with the other approaches, we believe. Incorporating crossover could increase exposure to issuers with improving fundamentals.  And it could enhance yield and capture more spread for a relatively lower credit risk than the sub-BB high yield10.

Current market conditions mean careful implementation is key to maintaining optimal credit quality. Our approach to investing in crossover emphasizes quality, with additional focus on low turnover. This means that our pooled strategy requires less frequent trading than traditional benchmark approaches, We use sustainability as a lens through which to appraise credit quality, and build safer and more resilient portfolios10.

For buy and maintain investors with cashflow requirements, a deep pool of crossover supply may facilitate tailoring of a portfolio for specific yield and maturity requirements. The large universe of outstanding crossover bond supply allows us to compose a portfolio from a broad selection of credits, giving us added flexibility for implementation, as well as to incorporate investor constraints.  For instance, we look to mitigate turnover by reducing idiosyncratic risk and moderating transaction costs.  

Maturity and duration constraints can also be taken into account.  Due to current market conditions, we believe a dedicated focus on quality is key.

In light of the overall risk-reward characteristics, a crossover strategy could prove an apt complement to credit investors.

Please find key terms in the glossary.

sources.

As of 31 January 2018, the crossover segment of the global bond universe amounted to nearly USD7 trillion in market value.  Source: LOIM, Barclays POINT, Bloomberg Barclays Indices. 
Crossover yield vs global investment grade yield, and spread differential vs duration-matched US Treasuries; Source: Bloomberg Barclays point as of 31st Dec 2018.
3 There can be no assurance that these objectives will be achieved or that there will be a return on capital.
4 Source, Barclays POINT and LOIM, based on average spread returns from Jan 2004 to Dec 2018. Past performance does not guarantee future results and can be misleading
5 Source: LOIM calculations based on Moody’s Annual Default Study: Corporate Default and Recovery Rates 1920-2017. Past performance does not guarantee future results and can be misleading. There can be no assurance that these results will be achieved or that there will be a return on capital.
6 Yield expectations are subject to change and may vary over time.
7 Based on average 3y transition rates for Global Corporate from 1981-2016; Source: Standard & Poor’s, 2016 Annual Global Corporate Default Study and Rating Transitions, May 2017; and LOIM calculations. Past performance does not guarantee future results and can be misleading.
8 Based on drawdown by rating category June 2004-December 2018, Source: Barclays POINT, Barclays Indices, LOIM calculations. Past performance does not guarantee future results and can be misleading.
9 These investment scenarios are often observed in credit markets.
10 There can be no assurance that these objectives will be achieved or that there will be a return on capital.

important information.

This communication was prepared by Lombard Odier Asset Management (Europe) Limited. The information contained in this communication does not take into account any individual’s specific circumstances, objectives or needs and does not constitute research or that any investment strategy is suitable or appropriate to individual circumstances or that any investment or strategy constitutes a personal investment advice to any investor. This communication is not intended to substitute any professional advice on investment in financial products. Investors should take care to assess the suitability of such investment to his/her particular risk profile and circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. The information and analysis contained herein are based on sources considered reliable. Lombard Odier makes its best efforts to ensure the timeliness, accuracy, and completeness of the information contained in this communication. 

Nevertheless, all information and opinions, as well as the prices, market valuations and calculations indicated herein, may change without notice. Source of the figures: Unless otherwise stated, figures are prepared by Lombard Odier Asset Management (Europe) Limited. The tax treatment depends on the individual circumstances of each client and may be subject to change in the future. Lombard Odier does not provide tax advice and it is up to each investor to consult with its own tax advisors. 

European Union Members: This communication has been approved for issue by Lombard Odier (Europe) S.A. The entity is a credit institution authorized and regulated by the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg. Lombard Odier (Europe) S.A. branches are operating in the following territories: France: Lombard Odier (Europe). S.A. Succursale en France, a credit institution under limited supervision in France by the Autorité de contrôle prudentiel et de résolution (ACPR) and by the Autorité des marchés financiers(AMF) in respect of its investment services activities; Spain: Lombard Odier (Europe) S.A. Sucursal en España, Lombard Odier Gestión (España) S.G.I.I.C., S.A.U., credit institutions under limited supervision in Spain by the Banco de España and the Comisión Nacional del Mercado de Valores (CNMV). 
United States: Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States or given to any US person. 
This communication may not be reproduced (in whole or in part), transmitted, modified, or used for any public or commercial purpose without the prior written permission of Lombard Odier. 
© 2019 Lombard Odier Investment Managers – all rights reserved.