Crossover bonds: strong fundamentals and the BB boost

Corporate bond investors are often considered secondary to equity investors in terms of their influence on the firm. Indeed, maximising shareholder value as popularised by Milton Friedman in the 1970s is a defining tenet of business ethics. This makes shareholders the ultimate beneficiaries of corporate decisions at an economy-wide level, but is not necessarily true for specific issuers. 

The seminal work of Robert Merton (1974)¹ models equity as being long a call option on the assets of the firm and corporate debt as being short a put option on the assets of the firm. This characteristic creates a crucial difference between corporate bonds and equities that leads to differing incentives for equity and debt holders. Equity holders, as they are effectively the holders of a lottery ticket, have a greater incentive to make the firm riskier. Corporate debt holders, on the other hand, have an incentive to make the firm less risky because it reduces the value of the put and therefore increases the value of the bond². 

We argue that debt holders increasingly exercise control by de-risking the business³ and reducing leverage as a bond moves closer to the IG-HY rating threshold. The BBB to BB rating category also constitutes relatively large companies that avoid the jump-to-default and liquidity concerns seen in the B and lower-rated segments. 

Figure 1A calculates net annualised downgrade rates (upgrade less downgrade notches) over the past 30 years. Indeed, corporations in general tend to deteriorate in credit quality following Schumpeter’s idea of creative destruction⁴. However, there is significant variation across rating categories. Figure 1A calculates the net upgrade rate (upgrade less downgrade) of corporate issuers by their initial rating to show that highly rated companies (A or better) as well as low-rated companies (B and lower) tend to have a high propensity to be downgraded. BBB and BB rated bonds, on the other hand, tend to improve their ratings as evidenced by a positive net upgrade rate. Fundamentals tend to improve the most at the IG-HY threshold for BBB- and BB+ bonds. 

Figure 1B explains this anomaly: equity performance tends to be the strongest for higher-rated companies, declining as the company is downgraded to BB and below. This clearly highlights the tension that exists between equity and bond holders, which results in a greater prioritisation of the bond holder at the threshold between IG and HY. Companies that are downgraded to BBB and BB try to improve their credit quality by selling assets or reducing dividends. In stress periods, the most productive assets are generally sold. Consequently, these actions tend to benefit the bond holder at the expense of the equity holder.

Figure 1. Fundamentals and performance by credit rating

Source: LOIM, Moody’s, Bloomberg Barclays Indices. For illustrative purposes only. As at end-December 2023.
 

sources:

1  Merton, R. (1974). On the Pricing of Corporate Debt: the Risk Structure of Interest Rates. Journal of Finance, 29(2), 449-470.
2  The Merton model assumes that the value of the firm is invariant to the capital structure in line with Modigliani-Miller (1958). Therefore, there is no ‘optimal’ capital structure for the firm. This assumption has
been relaxed in papers such as Leland (1994, 1996) who also calculate an optimal capital structure in the presence of bankruptcy costs and taxes.
3  Covenants is a direct mechanism to exercise control.
4  Schumpeter, Joseph A., The Theory of Economic Development. New York: Oxford University Press, 1934.
 

The improvement of fundamentals is not the only reason for our structural preference for crossover. Valuations also play a very important role, especially in the BB rated segment of corporates. Figure 2A shows that the performance of BB rated bonds is higher than other rating categories, including the lower-rated B category. BB bonds appear to have anomalously high returns when compared to their risk characteristics. Figure 2B illustrates that BB rated bonds have the highest risk-adjusted returns across ratings-based categories.

Figure 2. Corporate bond total return by credit rating: 2002 – 2023
 

Source: LOIM, Bloomberg Barclays Indices. Calculated using monthly data, as at end-December 2023. Past performance is not a reliable indicator of future returns.

Taking into account credit excess returns further strengthens the valuation argument. Credit excess returns strip out the impact of differences in duration by calculating returns in excess of matched treasuries. Figure 3 indicates that the results are similar for excess returns, with BB rated assets being the outlier especially in terms of Sharpe ratios.

Figure 3. Corporate bond excess return by credit rating: 2002-2023

Source: LOIM, Bloomberg Barclays Indices. Calculated using monthly data, as of end-December 2023. Past performance is not a reliable indicator of future returns.

The outperformance of BB rated assets is strongly linked to the outperformance of bonds downgraded from IG, known as fallen angels. We have extensively documented the performance of fallen angels in a series of white papers. Broadly, we find that downgraded bonds over-react relative to their fundamentals and this over-reaction reverses after the downgrade over the next two years. Figure 4B shows the performance of downgraded bonds vs their peers as a function of time since downgrade. Figure 4A shows that the performance of BBs is significantly enhanced by fallen angels, with traditional BB risk adjusted performance more in line with B assets. 

Figure 4. Impact of fallen angels on BB performance
 

Source: LOIM, Bloomberg Barclays Indices. Calculated using monthly data, as of end-December 2023. Past performance is not a reliable indicator of future returns.

While the crossover investment universe has increased substantially, many investors still do not straddle the two universes for various reasons, including expertise and regulations. Murray & Nikolova (2018) show that bonds with a high propensity to be downgraded to non-investment grade (BBB-) outperform other IG bonds on a risk-adjusted basis. The authors argue that selling pressure from insurance companies – which hold over a quarter of the outstanding corporate bonds universe in the US, as shown in figure 5A – is one reason for this outperformance. Figure 5B shows that capital charges for insurance companies increase by 3.5x for a single notch downgrade from BBB- to BB+. 

Regulatory pressures driving underperformance of highly rated bonds is also addressed by Becker & Ivashina (2011), while forced selling resulting in outperformance of downgraded bonds is documented by Ellul & Lundblad (2011) and Ben Dor & Xu (2011). These regulatory pressures remain a factor and are likely to persist for the foreseeable future, providing a continued source of valuation support for BB and lower BBB rated assets.

Figure 5. Insurance company holdings of corporate bonds and regulatory drivers

Source: US Federal Reserve. As at March 2023.

Rate and credit risk are two factors driving the performance of all credit products. Indeed, investment grade, crossover and high yield can be considered on a continuum where the share of rates and credit contribution to risk and returns varies, with credit risk increasing for lower credit quality. Figure 6 shows that investment grade is dominated by rates (or duration) for both return and risk perspectives, while high yield is driven by credit. Crossover sits in the middle, thus historically has been better balanced between the two. 

Figure 6. Return and risk contributions by ratings category: 2004 – 2023
 

Source: LOIM, Bloomberg Barclays indices. As at end-December 2023. For illustrative purposes only.

For many investors, volatility is a less relevant measure of risk. Insurance companies, which are among the largest investors in corporate bonds, tend to be capital constrained. For such investors, capital charges are a better analogue to risk. Capital charges tend to increase with both duration and ratings. For European insurers, capital charges⁵ for corporate bonds double between AAA and BBB ratings followed by another doubling between BBB and BB ratings, as illustrated in figure 7A. However, as we see from figure 7B, the return per unit of capital is higher on crossover than on an equivalent mix of investment grade and high yield due to the trade-off between spread and duration. 

In general, both credit spreads and duration tend to increase the risk and solvency capital requirements of corporate bonds. This is consistent with the use of duration times spread (DTS) as the preferred risk measure for spread risk in corporate bonds. However, credit returns are only loosely linked to duration and much more strongly connected to spread levels. A crossover portfolio, therefore, replaces high-duration and low-spread bonds in the A or better segment with low-duration and high-spread bonds in the BB segment. This results in a greater increase in credit returns than solvency capital charges.

Figure 7. Capital charges for insurer holdings of corporate bonds and credit excess return
 

Source: LOIM, Bloomberg Barclays Indices. As at end-October 2023.
 

source:

5 We use the standard model based on the Solvency 2 spread-risk module. Note that most insurance books have relatively hedged rate exposure versus liabilities, with credit risk and equity risk being the main user of capital.

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