Crossover credit: Filling the gap
Joseph Mariathasan sees opportunities in crossover credit
At a glance
• Investment-grade funds can benefit from including highest rated high-yields bonds.
• Leverage of crossover credits tends to improve over time.
• Fallen angels account for much of the characteristics of crossover credit.
• Investors should be aware of supply issues.
The search for yield has become an overriding concern for institutional investors. Investment-grade credit investors in particular, have seen both yields and spreads tightening to levels that have become painful. For those investors with the mandate to do so, one option is to move further down the credit spectrum into the top end of the high-yield market.
Indeed, many investment-grade funds have a mandate that allows them to invest a significant minority of investments into sub-investment-grade debt. Such ‘crossover’ opportunities are an important factor in the dynamics of the high-yield markets with 55% of the global high-yield universe rated BB. Of the rest, 34% is rated B with the remaining rated CCC, according to Vivek Bommi, portfolio manager at Neuberger Berman.
There is significant added-value potential from combining the lowest level of investment grade (BBB+ to BBB-) and the highest level of high yield (BB+ to BB-) argues Yannik Zufferey, fixed-income CIO at Lombard Odier Investment Managers (LOIM). In particular, BB-rated bonds have provided substantially higher yields than investment grade or BBB-rated credit.
Zufferey argues that there is a better balance of duration and credit risk than the investment-grade universe; higher yield and return potential than investment-grade portfolios; positive dynamics relative to the investment-grade universe; and lower default and drawdown risk compared with the high-yield universe.
LOIM also finds that the leverage of lower-rated investment grade (BBB-) and BB issuers appears to improve over time, whereas the opposite is true for A-rated and high BBB-rated issuers. Zufferey sees a general trend among higher-rated companies to try to optimise their balance sheets , invariably leading to an increase in debt and leverage as the downside is low.
In contrast, issuers with a rating of BBB- and BB are conscious that the price of their debt would increase and access to additional debt could reduce as a result of such action, therefore making them more likely to take steps to support their balance sheet. “These trends favour the crossover segment which, on average, have improved their fundamentals relative to the investment grade universe,” argues Zufferey.
Fallen angels – previously investment-grade credits that have been downgraded – account for a large element of the behaviour of crossover credits. Last year there was $150bn (€139bn) of new fallen angels, dominated by mainly commodity names, according to Bommi.
Fallen angels account for 40% of the euro-zone BB-universe and nearly 20% of the US universe: “Over time, they become accepted as just another part of the high-yield market and are analysed on their merits, irrespective of origin,” Bommi says, although he notes that the behaviour of fallen angels can be spectacular – General Motors, almost 4% of the market at its peak, went from investment grade to BB to default.
As well as downside risks, fallen angels can also have large upside potential. When an investment grade credit is downgraded, investment-grade-only funds are forced to sell the bonds, thereby increasing the supply of new high-yield credits. Zufferey argues that the high-yield investor community does not provide a counterbalancing demand, as such investors are usually smaller and less familiar with the issuer. As a result, the demand-supply mismatch results in fallen angels dropping below the fair price as suggested by fundamentals. Over time, as the selling pressure subsides, the price recovers and rises to the fair market price.
Moreover, as Peter Aspbury, high-yield portfolio manager at JP Morgan Investment Management (JPMIM) adds, a lot of these companies are desperate to become investment grade again: “Recent examples have included Lafarge and HeidelbergCement. Telecom Italia, the biggest issuer in the market, already has one investment-grade rating but would like two others.” For fallen-angel investors, a lot of value is added by finding those companies that are likely to be uprated back into investment grade.
Thomas Ross, portfolio manager at Henderson Global Investors, is more sceptical of the arguments for crossover credits. His view is that fallen angels have larger capital structures and tend to be over researched: “Over a cycle, we would say there is more value in single Bs than crossover,” Ross says. He generally finds more opportunities lower down the rating spectrum in single-B and CCC credits. Issuers are smaller, so the large funds do not invest there. There are also a large number of issuers, so fund managers need more resources for analysis.
While many high-yield managers would generally prefer to fish lower down the credit spectrum, their behaviour has changed, given the significant compression of spreads in 2016. In euro high yield, at the end of January there was around a 150bps differential between B and BB. This has been as high as 300bps over the last three years and only ever as low as 130bps, Ross notes. On a risk-return trade off, the extra risk entailed by moving below crossover credits is not rewarded by much extra return. As a result, managers such as Aspbury have become much more enthusiastic about crossover credits.
Bommi also points out that while fallen angels are an important component of the BB segment, there are many good high-BB companies that become investment grade if management so wishes. In many cases, he contends, management believes the firm would get no benefit from the equity markets by becoming investment grade and so is happy to capitalise as a high-BB company.
In contrast, others believe they are at a competitive disadvantage if they are not investment grade. These issuers would rather bear less risk on their balance sheets and aim to become investment grade.
As Bommi explains, it makes sense for commodity companies to be investment grade to give them a stronger balance sheet in the next downturn. Less cyclical, less high-growth companies – cable companies or packaging firms, for instance – are comfortable operating in the high-BB segment because their earnings are less volatile: “While there may be better upside potential in names that could go to investment grade, other names could still give good value,” says Bommi.
Supply and demand shocks are a major issue for crossover investors. Ross argues that the BB segment tends to be crowded out by large investment-grade funds, whose managers look to high yield to boost their otherwise low yields. The large asset volume of these funds means they can have a big impact when they move.
Fallen angel upgrades can also cause severe shocks. Telecom Italia has €16bn of bonds in European high-yield indices. If its credit ratings are upgraded to investment grade, that capital would move out of the high-yield universe, points out Aspbury. “That figure represents almost twice the net inflows that European high-yield funds have received over the past two years. With net issuance in European high yield so low, any return to investment grade by a large fallen angel would give rise to a significant technical squeeze.”
Yet the Trump administration offers hope of new supply to high-yield investors. The US President’s focus on deregulation and fiscal expansion could lead to greatly increased M&A activity, which would be a blessing. As Aspbury concludes: “Nothing creates more fallen angels than M&A.”