Credit: X marks the spot

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The hinterland between investment grade and high yield delivers an intriguing risk profile. But Martin Steward also finds that it has been changing rapidly

Whisper it quietly, but there is one place on the credit spectrum that seems to deliver a better risk-adjusted return than anywhere else. The bonds world calls it ‘crossover’: those credits lingering at the very bottom of investment grade (BBB-) down to those poised at the very top of high yield (BB).

Lombard Odier has recently launched its 5Bs Bond fund specifically to exploit opportunities in this credit hinterland within Europe. According to its analysis of Barclays Capital figures from 2003-10, while investment grade (IG) and crossover shared similar volatility (3.5%), crossover delivered a return of 5.39% versus IG’s 4.09%. European high yield (HY) delivered 8.18% returns from 9.16% volatility over the same period. In terms of Sharpe ratio that translates to 0.89 for HY, 1.27 for IG and 1.52 for crossover.
Worth €400bn, Europe’s crossover universe includes some household names: British Airways, Cable & Wireless, Fiat, Kabel Deutschland, Lafarge, Renault, ThyssenKrupp, Fresenius. “The ‘5Bs’ universe is not a niche,” as Lombard Odier’s fixed income and currencies CIO Stephane Monier puts it.

So why is it such a good place to be? If you are benchmarked against an IG index, your BBB- names face the constant threat of being downgraded and dropping out of that index. You might have a 10% HY ‘bucket’, or perhaps some leeway to hold the bonds for another 90 days, but ultimately you will be forced to sell some credits. If you are benchmarked against a HY index, being overweight lower-yielding BB names is hardly the way to outperform that index.

This is where that extra yield per unit of risk comes from: it is a liquidity premium paid for filling the awkward gap between IG and HY portfolios. And crossover investors can be paid that premium to own some high-quality names, whether ‘rising stars’ on their way up to IG, or ‘fallen angels’ that have temporarily dropped out. To the list above one might add HeidelbergCement, downgraded to junk in 2008 when it looked like it would break its covenants: since then it has refinanced with some heavily over-subscribed issues and is growing earnings.

In the US one might pick out Macy’s, which went into the credit crisis highly leveraged, got downgraded, changed management and began to tidy up its balance sheet. Klaus Blaabjerg, portfolio manager in high yield at Sparinvest picks out UPM-Kymmene: he says that its risk is much less than implied by its downgrade, thanks to extensive non-core assets, and he points out that Finnish investors buying its euro-denominated bonds “are pricing it spot-on”. It is the sterling- and dollar-denominated bonds that “have introduced some inefficiencies” - perhaps reflecting the dominance of benchmark-constrained international investors.

But as well as bottom-up rationales like these, there is a compelling top-down one. Crossover’s nice mix of mutually diversifying credit and duration risks leads to a changing liquidity profile through the credit cycle. At the moment IG portfolios are dipping into crossover searching for yield, while HY portfolios are more likely to be moving down towards single-C. Crossover investors get a liquidity discount from the HY investors for ‘rising stars’, which they can cash in using the liquidity coming from IG investors. In a recession, IG investors flee to their AA names, leaving a liquidity discount on ‘fallen angels’ and low-rated credits for cross-over investors, which they can cash in using the liquidity coming from HY investors moving up into BBs. Of course it’s not quite as simple as that: there tends to be a lag of three to six months before the spreads at which IG offers become the spreads at which HY bids - which is why crossover investors get paid that premium.

“Behavioural finance will tell you that the day before that happens, you’ve sold because you’re terrified,” says Martin Reeves, director of global credit research at AllianceBernstein. “You’ve got to be able to live with the pressure of the price going down.”

Bottom-up fundamentals are clearly important in crossover. Price action can make all ‘fallen angels’ look bad - and many will indeed be value traps. “Fallen angels have roughly 50% greater probability of being upgraded back to investment grade than the typical high yield name in the same ratings bucket,” says Peter Greatrex, head of research at Blue Mountain Capital. “But they also have a greater probability of default.”

‘Rising stars’ present their own risk, too. Finance officers for fast-growing, cash-generative business have good reason to sweat balance sheets in a way that may not be compatible with BBB metrics, and these incentives are even stronger during an upturn when spreads (and therefore the costs of borrowing) between BBs and BBBs compress. Telecoms and healthcare provide many examples, and building materials in the US. “Every time Fresenius’ metrics begin to look like BBB they re-lever,” observes Jonathan Butler at Pramerica Investment Management.

Some firms, particularly in the US, will go so far as to acquire a lower-rated competitor to re-leverage. This points to another big risk in crossover: M&A. Because many names are value plays they become acquisition targets. Mirko Santucci, head of credit at Swisscanto, recalls buying Chespeake Energy three weeks before its shale gas assets were bought by BHP Biliton, for example. But he also admits that the only crossover position that has turned sour for his portfolio was Axcan Pharma, downgraded from BB- to B+ after making an acquisition. And being acquired by BHP Biliton clearly has a different effect on credit rating than being acquired by a private equity house.

“This emphasises the importance of spending time on the structural elements, such as which bonds are subject to change of control language,” says Greatrex. “The performance of different instruments can diverge dramatically for a given event.”
So the premium crossover pays seems is related to the liquidity investors must forego in the face of these risks. Investors must therefore understand how the liquidity profile of crossover might be changing.

Most notable is the increasing flexibility of IG mandates to hold HY. This is limited and slow-moving but nonetheless one might see the paltry 5% yield on offer from BBs as evidence of more activity there from flexible IG and unconstrained funds, or the fact that building materials firm Lafarge does not seem to have suffered a rejection by worried IG investors despite teetering on the margins of BBB-.

“It’s notable that Lafarge has not really widened much after the most recent downgrade,” says Philippe Igigabel, euro high yield portfolio manager at HSBC Global Asset Management. “That suggests to me that fewer investors are ratings-constrained.”

There is a devil in the detail - Edward Farley at Pramerica notes that the Lafarge bond with ‘step-up language’ (compensating investors in the event of a downgrade) has outperformed recently, for example - but the overall point seems fair. Some companies - Renault, Peugeot, Fiat, Lufthansa, HeidelbergCement, Continental, perhaps soon Lafarge - are essentially IG names rated at BB. “Investment grade accounts would probably hang on to these and ride the whole cycle,” as Hans Stoter, head of credit at ING Investment Management, puts it.

Which is why HY and crossover investors aren’t interested. This time around there has been a better alternative: “In this cycle the fallen angels story has been all about subordinated financials,” as Steve Logan, head of European high yield at SWIP, observes. The financial crisis saw a tonne of this paper downgraded to junk and dumped by IG investors, and HY investors have shunned it because they are not used to analysing all that sovereign and regulatory risk. Crossover investors get to take the liquidity discount from IG investors and wait for upgrades.

If you don’t like banks, high yield managers like Alexandre Caminade at Allianz GI Investments Europe point instead to the abundant supply of BB senior secured credits from single-B issuers, like Ardagh Packaging, Virgin Media and Uno Telecom, which took advantage of rock-bottom rates to refinance and extend their maturities.

And the rates story suggests a third opportunity. While IG investors are increasingly holding onto their non-financial ‘fallen angels’, they may also begin to reach down for more credit risk as rates threaten to rise, providing liquidity for these financials, senior secured BBs and even single-Bs. At the same time, there will come a point when rising rates will force HY investors to re-assess their lower-grade credits. “Where do you want to be in high yield when rates start to go up?” wonders Felix Martin, economist and analyst in the global credit team at Thames River Capital. “There is a long tail of firms whose EBITDA barely covers their interest payments.” Add all of this to the mountain of cash that HY funds got from investors in 2010, and we could see a significant migration of liquidity into ‘5Bs’ as rates go up - Fiat Industrial’s four-times oversubscribed BB+ issue on 7 March suggests that we already are.

However, all three of these phenomena - subordinated financials, senior secured BBs from single-B issuers, the bounce off two-years of low rates - are particular to this post-crisis cycle. Only the financials opportunity looks anything like the traditional ‘fallen angel’. Indeed, the potential drift up the credit spectrum by HY investors in a rising rate environment cuts across the usual crossover liquidity pattern.

So crossover looks like a great short-term opportunity. But will it remain the great long-term opportunity that it has been in the past? Its liquidity profile is changing, slowly but surely. Investors need to ask what that means for the premiums on offer there.



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