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Crossover: the credit sweet spot
The crossover area of corporate bonds could provide investors with a sweet spot in terms of the returns available relative to the potential risk, in our view.
Historical developments in corporate bond markets created a somewhat artificial boundary between ratings. This resulted in a bifurcation between investment grade (IG) credits and high yield (HY) credits, with each seen as appealing to separate classes of investors.
The boundary also created dislocations in an asset class that straddles both universes: the crossover segment of BBB to BB rated bonds.
We believe this crossover segment provides an interesting structural opportunity for investors. From a risk-return perspective, crossover bonds could significantly improve investment grade returns1, but with similar risk, in our view. Historically, crossover bonds have shown comparable or even lower volatility than investment grade credits whilst exhibiting similar drawdowns2.
Valuations for crossover bonds however tend to be much better than investment grade with substantially higher spreads. “Fallen angels”, or bonds that migrate from investment grade to high yield, are strong drivers of this excess valuation especially in volatile times.
As for issuer fundamentals, we argue that crossover issuers have a propensity to improve their fundamentals as corporations historically have preferred a deleveraging strategy when close to the IG-HY threshold3.
The crossover universe could serve as a replacement for investment grade strategies, owing to similar risk characteristics, sector distributions and ratings, in our view.
Active investment grade managers tend to also follow a crossover-type strategy with a systematic over-exposure to credit and underweight to rates – this is indicative of an exposure to BB rated bonds at the expense of higher-rated issuers.
We believe that the combination of better valuations, improving fundamentals, low risk and diversification makes crossover the sweet spot of the credit spectrum.
Please find key terms in the glossary.
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sources.
1 Past performance is not a guarantee of future results. Yields are subject to change and can vary over time.
2 Refers to volatility and drawdown of crossover vs other rating from June 2004 to February 2019. Source: Bloomberg Barclays indices, LOIM calculations.
3 Source: LOIM calculations. Moody’s Annual Default Study: Corporate Default and Recovery Rates,1920-2017.
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