Fixed-Income Insights

Elevated prices for ‘BB’-rated securities in both the high yield bond and leveraged loan markets suggest better value and upside in certain lower-rated credit.

 

In Brief

  • Despite a segment-wide rally during December, the full-year performance of U.S. lower-quality credit in 2019 was anomalous with ‘BB’-rated securities outperforming in an otherwise favorable market environment.
  • Analyzing data starting from 2012, we found that BB bonds underperformed the broader high yield category 75% of the time over the ensuing 12-month period, with a median underperformance of 1.88% when BBs were at a level of call constraint similar to or greater than today.
  • Similarly, in the leveraged loan market, when BB bonds exceeded the current BB index price, they underperformed 81% of the time over the ensuing 12-month period, and the median underperformance over all these periods was 0.86%.

 

As we move into 2020, investors are looking beyond 2019’s solid performance across much of the leveraged finance markets to consider the potential investment themes that may play out over the next 12 months.  While we typically don’t find much value in simply recapping prior performance, it is notable that despite an outsized rally in ‘CCC’-rated securities in December, ‘BB’-rated issues still strongly outperformed CCCs across both the high yield bond and leveraged loan markets for the full year. That outcome was consistent with other asset classes as well, with the bid for safety overshadowing lower quality, higher beta segments within many asset markets for most of 2019.  

However, in our opinion, the safety bid may be reaching a dead end. We have seen some thawing in U.S.-China trade tensions and related prospects for continued macro improvement, especially in light of some initial “green shoots” in recovering manufacturing and corporate confidence. Some investors may see these developments pushing off the end of the economic and credit cycles beyond 2020.

Constrained Upside in BBs?
But what’s the setup for the high yield and leveraged loan markets now, as segmented by credit quality? In Chart 1, we track through time the par-weighted percentage of ‘BB’- and ‘B’-rated bonds, and the overall high yield market, that are trading at or near their next call price (“call constrained’). With 2019’s BB outperformance behind us and an index of BB corporate bonds today at an average price of $104.9, over 80% of the par value of BBs is call constrained, compared to just 60% in the ‘B’-rated category. Further, note that BBs were similarly constrained at times during 2013 and 2014, but Bs today are not yet at the same levels of upside constraint as they were in during that period.

Why are these comparisons important? They show that these above-par BBs face significantly asymmetric risks: price upside is limited because yield declines may result in a call of these securities by issuers, while yield increases may result in significant price declines from interest rate sensitivity and term extending from the next call date to maturity date.

Similarly, on the right side of Chart 1, we track the weighted average dollar price across ratings cohorts in the leveraged loan market. Recall that loans are typically callable by the issuer after the first six months after issuance (typically at $101), so the call constrained characterization of the high yield bond market isn’t exactly transferable to an analysis of the loan market. Nonetheless, on a relative value basis, we find that the overall leveraged loan index today is around $96.64 compared to $101.4 for the broader high yield bond market. We believe that alone is a modest relative value argument in favor of loans, simply based on price terms.

But perhaps more importantly, as with bonds,’ BB’-rated loans look more upside constrained in price terms relative to Bs. Indeed, a quick glance at the chart shows that a similar price gap that existed in late 2016 closed thereafter with BB loans trading sideways (i.e., near par), while the rest of the loan market moved higher in price terms.  And we are seeing some of the negative implications of elevated prices in BB loans already with the recent pickup of repricings in BB loans. The astute reader will note that we haven’t tracked the index price for ‘CCC’-rated loans (currently at $80.80), but at just 6.2% of the market value outstanding, the omission of the lowest speculative-grade tier likely won’t influence most investors’ assessment of the loan market, in our view.

 

Chart 1. Upside for ‘BB’-Rated Securities Appears Limited in Both the High Yield Bond and Leveraged Loan Markets
Percentage of bonds (left panel) trading at or near next call price, and loan index prices (right panel), by indicated category, December 31, 2011–December 31, 2019

Source: Bloomberg. HY Index=Bloomberg Barclays U.S. High Yield Index. LL Index=Credit Suisse Leveraged Loan Index. Data as of December 31, 2019.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.
 

What Past Price Trends May Suggest for ‘BB’-Rated Bonds
Next, we look to history as we consider how the various ratings cohorts across leveraged finance could potentially perform over the coming year given the current state of elevated BB prices relative to Bs and the rest of the bond and loan markets.  In Chart 2, we focus first on the high yield bond market (left panel).  Using monthly data from 2012 (appreciably long after the market distortions around the 2008-09 recession, and ensuing price recovery), we plot the percentage of BBs characterized as call constrained at each month versus the ensuing 12-month total return difference versus the broader high yield market.  

  • In months where less than 80% of the par value of BBs is call constrained, BBs underperformed the broader high yield market just over half the time (34 out of 65 observed 12-month rolling periods) with a median of 0.19% of underperformance; essentially, a coin-toss.
  • But on the flip side, when BBs were more than 80% call constrained (a touch lower than the the 86% today), BBs underperformed broader high yield more frequently and with greater intensity: 75% of the time (15 out of 20 observed 12-month rolling periods) with a median of 1.88% of underperformance over all these periods.

 

Chart 2.  History Suggests Higher-Priced ‘BB’-Rated Bonds and Loans May Be Poised to Underperform
Data for the period December 31, 2011–December 31, 2019

Source: Bloomberg. HY Index=Bloomberg Barclays U.S. High Yield Index. LL Index=Credit Suisse Leveraged Loan Index. Data as of December 31, 2019. The chart on the left depicts the 65 observed ensuing 12-month rolling periods during the December 31, 2011–December 31, 2019 timeframe in which less than 80% of the par value of ‘BB’-rated bonds was call constrained (trading at or near their next call price)  and the 20 periods when more than 80% of BBs were call constrained, and the performance of these periods in comparison to the ensuing 12-month total return difference versus the broader high yield market, as represented by the Bloomberg Barclays U.S. High Yield index. The chart on the right depicts the 43 observed ensuing 12-month periods during the December 31, 2011–December 31, 2019 timeframe when the average price for ‘BB’-rated loans was below the level of $99.81 at December 31, 2019, and the 42 periods exceeding the $99.81 level, and the performance of these periods in comparison to the broader loan market, as represented by the Credit Suisse Leveraged Loan Index.

The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

 

Next to a similar analysis of the loan market, we find:

  • In months where the BB loan price index was below the current level of $99.81, BBs underperformed just over half the time (24 out of 43 observed 12-month rolling periods), and BBs trailed the broader loan market by a median of 55 basis points (bps) over these periods.
  • But when BBs exceeded the current BB price index, they underperformed 81% of the time (34 out of 42 observed 12-month rolling periods) and the median underperformance over all these periods was 0.95%.

While there are a number of performance statistics above, and other ways we could segment the data more finely, our takeaway here simply is that given high dollar prices for BBs in both the high yield bond and leveraged loan markets, we believe that prospects for BB-heavy strategies look poor from here. Certainly there are other market environments, such as when an economic downturn seems more imminent, where an up-in-quality constrained bias may be warranted. But we don’t believe such fears should be the base case, even though they appear to be reflected in the price of bonds and loans today.

Summing Up
We have long emphasized that one of the differentiated strengths of our leveraged credit platform is our inherently unconstrained approach to portfolio construction that allows us to migrate up and down in credit quality as the spread opportunity and macro environment warrant. As credit rallied through 2019, we decreased our BB exposures in both high yield and leveraged loans, finding better value in other segments of the credit markets. We maintain that preference away from BBs going into 2020, a stance we believe will benefit performance should our view on the extension of the credit and economic cycles be proven correct.

 

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of Terms

Call options are financial contracts that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other asset or instrument at a specified price within a specific time period.

risk premium is the return in excess of the risk-free rate of return an investment is expected to yield;

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

The Bloomberg Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.

Bloomberg Barclays Index Information:
Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality of the securities are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principle on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this article are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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