fixed income
Crossover bonds: a replacement for investment grade
This insight is the first of a three-part series about corporate credit rated BBB to BB, which is also known as crossover.
We begin by exploring how a ratings boundary arose between high-yield and investment-grade corporate bonds. The dislocations generated by this boundary create opportunities for fixed income investors in the ratings space of BBB to BB, or crossover1. The opportunities arise from how issuers behave to how assets perform, and mean that the crossover space is a large and liquid alternative to investment-grade debt.
In the sections below, we consider:
- The history of credit ratings, benchmarks and why this creates dislocations
- Why crossover provides a better risk-adjusted substitute than a combination of investment grade and high yield
- How crossover features historical default rates more in line with investment grade
- The strong parallels in sector allocation between crossover and investment grade
- Taking into these factors, we make the case for crossover as a suitable replacement for investing in investment-grade debt.
1 Crossover is also referred to as 5B.
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What are crossover bonds?
Corporate bond benchmarks have historically been divided into investment-grade (IG) and high-yield (HY) focused benchmarks. The first bond benchmark, the Lehman US Aggregate Index, was started in 1973 and consisted exclusively of investment-grade bonds. High-yield or speculative-grade benchmarks began in the late 1980s following the popularity of junk bonds in the 1980s that often fuelled leveraged buyout (LBO) activity. The popularity of benchmarking accompanies the rise of passive investing, with a majority of client assets invested along the two main benchmarks. Asset-allocation grids for institutional investors also group corporate-bond assets in these two broad categories.
The history of corporate-bond benchmarks has therefore resulted in a somewhat artificial boundary between investment-grade and high-yield bonds, each appealing to separate classes of investors. The boundary treats these two ratings segments as separate asset classes, whereas in reality they represent a continuum between allocating to credit risk and interest-rate risk.
This separation has also created dislocations, which influence both issuer behaviour as well as asset performance. We believe that these dislocations provide an interesting structural opportunity in a segment that straddles both universes: the crossover or BBB to BB segment.
The crossover market is no longer a niche segment, rising from less than 20% in 2001 to almost two-thirds of the size of the investment grade corporate market in 2023, as shown in figure 1A. An increase in the BBB rated universe, as shown in figure 1B, is a significant driver of this growth.
Figure 1. Evolution of corporate bond markets
Source: LOIM, Bloomberg Barclays Indices. As at end-December 2023.
This increase in BBB rated issuance is not due to BBB corporates leveraging, but rather a result of the effects set in motion by the Global Financial Crisis (GFC) of 2008-09 that led to the disintermediation of banks as lenders.
Using US data, we find a substantial reduction in loans2, as shown in figure 2, as banks de-risked after the GFC. Interestingly, a similar disintermediation pattern was seen in the early 1990s following the Savings and Loans Crisis.
Figure 2. Relative size of funding markets: US non-financial corporates
Source: Bloomberg, LOIM calculations. As at March 2023.Smaller corporations – that would have traditionally used bank loans as a source of funding – moved into public markets by issuing corporate bonds. Figure 3B shows a decrease in the size of companies issuing corporate bonds, as measured by their equity market-capitalisation, relative to the average equity market-cap. These corporations tend to be BBB rated and have been a major driver of the expansion of the BBB universe.
The downgrade of financials and issuance of more subordinated and bailable3 debt by banks further fuelled the proliferation of BBBs. Figure 3A shows that the average rating of financials has declined by nearly two notches (from A+ to A-) over the past 15 years. While this trend has made the overall financial system more stable, it also led to a general deterioration of ratings4 in this sector. Figure 3B shows that the average size by equity market-cap of the median equity issuer has increased relative to the median bond issuer. This indicates that relatively smaller companies are issuing bonds, potentially leading to a proliferation of BBB issuers.
Figure 3. Changes in corporate bond issuers – rating and size
Source: LOIM calculations, Bloomberg Barclays indices, Factset, Worldscope. Ratings are subject to change. As at November 2023.
As a result of these factors, the crossover segment is now a large and liquid alternative to investing in investment-grade. We believe that crossover also provides a better risk-adjusted substitute to simply investing in a combination of investment-grade and high-yield debt: crossover features a risk profile closer to IG and a return profile in between IG and HY.
sources:2 Although loans can also be provided by the capital markets including the leveraged loans industry, loans are largely provided by banks and dominated by smaller, private companies.
3 Currently, nearly all of a bank’s capital structure is bailable, allowing the continued survival of the bank in distress periods or an orderly resolution in case of a failure. AT1, LT2s and senior non-preferred debt are categories of debt that can be bailed-in in the event of distress.
4 Duffie (2018) asserts that for mitigating systematic failure, creditors would need to believe that they would experience a significant loss at solvency. This effect has manifested itself in lower ratings and higher spreads for banks despite a stronger balance sheet via the issuance of bailable debt.
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Crossover risk similar to investment grade but with improved returns
While crossover ratings straddle both investment grade and high yield, we believe that the crossover universe behaves similarly to investment grade and can be considered a replacement for investment grade.
Long-term performance for global crossover shows returns that are roughly between investment-grade and high-yield, as expected from an asset class that combines these two assets. However, from a risk perspective, we find a much greater commonality with investment-grade. This is true for all risk metrics, including volatility, drawdown or default risk, and results in the Sharpe ratio of the crossover segment being superior to both investment grade and high yield over the 22-year time sample in figure 4. Over shorter periods, the Sharpe ratio of investment grade appears to be biased downwards due to the historic drawdown seen in 2022.
Figure 4. Historical performance of global corporate bond benchmarks, 2000-2023
Source: LOIM, Bloomberg Barclays Indices. Past performance is not an indicator of future results. Yields are subject to change and can vary over time. As at end-December 2023. -
Default rates – closer to investment grade than high yield
For long-term investors that can withstand mark-to-market volatility, default risk might be a more appropriate measure of risk. We observe in figure 5A that default probability rises exponentially with credit ratings. For example, three-year high-yield default rates rise exponentially after BBB, with a 2.5x increase from BB to B and a 2x increase to CCC. Figure 5B highlights this clearly, showing the annualised default rate of crossover is much closer to IG than it is to HY.
Figure 5. 3-year annualised default risk by rating
Source: Moody's. As at end-2023. -
Sector allocation – closer to investment grade than high yield
The sector allocation of the crossover universe has changed substantially since 2000, converging strongly with IG markets. The increased diversity of issuers, especially within the BBB rated universe, combined with the downgrade of financials to make this universe much more representative of the broad investment-grade corporate bond market. Therefore, an allocation to crossover does not involve any systemic sector bets.
Figure 6: Sector allocation: global crossover difference vs IG, 2000 and 2023Source: LOIM, Bloomberg Barclays Indices. As at end-December 2023.
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