Exploiting the two-way traffic in high yield
Tom Ross, corporate credit portfolio manager, takes a drive in the auto sector to demonstrate how both upgrades and downgrades can be a source of returns.
Key takeaways
- The crossover space between investment grade and high yield is often replete with pricing inefficiencies, providing fertile opportunities for investors prepared to conduct careful fundamental analysis.
- Identifying bond issuers that might be upgraded is a key part of successful credit investing but bonds that are downgraded into high yield can also offer opportunities due to technical market distortions.
In the first month of 2021 it was announced that Fiat Chrysler, the automaker, had been upgraded by S&P Global Ratings. The decision to move the rating from BB+ to BBB- meant the car maker now had two of the big three rating agencies rating it investment grade (Fitch also rates it BBB-), automatically qualifying it for investment grade status. As such, around €7 billion worth of Fiat Chrysler bonds will cross the divide.
This contrasts with last March when another big auto company – Ford – was downgraded from investment grade to high yield to become a so-called ‘fallen angel’. Back then, this caused US$36 billion worth of debt to move down into high yield.
Locating the stars
Investment grade rated companies are typically able to command lower yields from lenders so an obvious route to successful investing in high yield would be to identify ‘rising stars’ – those companies that are on a likely trajectory to achieving investment grade status. This would be a sound strategy: companies that move up through the ranks typically see their credit spreads narrow.
Yet there is a lot of truth in the old investment adage “it is better to travel than to arrive”. The factors that caused the upgrade of Fiat Chrysler had been circulating for some time, most notably the merger of the company with higher-rated rival auto group Peugeot to form a combined group called Stellantis. S&P noted that the benefits of economies of scale from this merger, improved geographic diversity and a stronger capital structure contributed to the upgrade decision. Holders of Fiat Chrysler bonds will have seen the prices of its bonds rise during late 2020 as investors in the market anticipated the ratings move.
Potential gains from further changes in credit rating may be less dramatic, simply because the distinction between an investment grade credit rating and a high yield credit rating is powerful in terms of index composition and its impact on the investor base. Passive investors and those with mandates that stipulate either investment grade or high yield can be forced to buy or sell whenever a bond crosses the divide.
The market is also made up of investors who might have different opinions on the outlook of a company. This can make the crossover space (the credit ratings area bordering the investment grade/high yield divide) somewhat nebulous in terms of valuations and it is not uncommon for some BBB rated companies to have higher yields than BB rated companies.
Taken together, these blurred lines of valuations, along with the technical impact of forced trading when bonds cross the divide, typically make the crossover space an area high in pricing inefficiencies and a fertile hunting ground for active managers.
When down is up
Returning to our opening story on automakers, the immediate assumption might be that it would have been a bad investment to hold Ford’s bonds after they were downgraded. Yet downgrades from investment grade to high yield can often be quite lucrative for active high yield investors. History has shown that on average credit spreads typically widen ahead of the downgrade and tighten after. The force behind this is often the strong technical impact of investment grade holders seeking to offload a bond they may no longer be permitted to hold after it is downgraded and high yield bond investors subsequently buying it.
This was in evidence with Ford. For example, Ford’s 7.45% 2031 USD bond sold off ahead of the date of the S&P downgrade (25 March 2020) and around the index rebalancing date at the end of March 2020 and then began to rise from early April (Figure 1).
Figure 1: Price of Ford Motor Co 7.45% 16/07/2031 USD
Source: Bloomberg, 31 December 2019 to 20 January 2021.
Past performance is not a guide to future performance.
But you might add – weren’t there other factors driving the bond price that had nothing to do with the downgrade? After all, the Ford downgrade coincided with the market sell-off caused by the coronavirus crisis and the economic lockdowns; most corporate bonds fell in March and rallied as 2020 progressed.
To make it a fairer comparison, let us plot a Ford bond against the US high yield market. To make it fairer still we will include just the BB rated bonds for the market (so we are not comparing with lower rated B and CCC bonds) and we will use a Ford bond that matures in 2025 so that it has a similar duration (interest rate sensitivity) to the BB rated market (around 4-4.5 years) so we help to cancel out any duration effect. In Figure 2 we have rebased the market, represented by the ICE BofA BB US High Yield Index, and the Ford bond to the date of the Ford downgrade. The chart demonstrates significant outperformance from the Ford bond since its downgrade.
Figure 2:
Figure 1: Price of Ford Motor Co 7.45% 16/07/2031 USD
Source: Bloomberg, Ford Motor Co 7.125% 15/11/2025 USD Bond, ICE BofA BB US High Yield Total Return Index, in USD, 31 December 2019 to 20 January 2021.
Past performance is not a guide to future performance.
Clearly, not every issuer downgraded into high yield will outperform following the downgrade. Some may see their bonds underperform if the credit fundamentals deteriorate. What this demonstrates however is that the high yield market is not as straightforward as it might appear.
Moreover, it can be advantageous for a credit analyst to cover the entire credit spectrum since this can help to maintain a continuous understanding of the fundamental drivers of a company regardless of its credit rating.
They say what goes up must come down but in the world of high yield bonds the reverse can be just as true.
Duration: A measure of a bond’s sensitivity to a change in interest rates, measured in terms of the weighted average of all the security/portfolio’s remaining cash flows (both coupons and principal). It is expressed as a number of years. The larger the figure, the more sensitive it is to a movement in interest rates.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
Marketing Communication.
Important information
Please read the following important information regarding funds related to this article.
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
- Callable debt securities, such as some asset-backed or mortgage-backed securities (ABS/MBS), give issuers the right to repay capital before the maturity date or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the fund may be impacted.
- If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund may invest in contingent convertible bonds (CoCos), which can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
Specific risks
- An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall. High yielding (non-investment grade) bonds are more speculative and more sensitive to adverse changes in market conditions.
- When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise (or are expected to rise). This risk is typically greater the longer the maturity of a bond investment.
- Callable debt securities, such as some asset-backed or mortgage-backed securities (ABS/MBS), give issuers the right to repay capital before the maturity date or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the fund may be impacted.
- Emerging markets expose the Fund to higher volatility and greater risk of loss than developed markets; they are susceptible to adverse political and economic events, and may be less well regulated with less robust custody and settlement procedures.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- The Fund may incur a higher level of transaction costs as a result of investing in less actively traded or less developed markets compared to a fund that invests in more active/developed markets. These transaction costs are in addition to the Fund's Ongoing Charges.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund may invest in contingent convertible bonds (CoCos), which can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares of the issuer or to be partly or wholly written off.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.