Is Now the Time for Sub-Investment Grade Credit?

(October 31, 2013) – High-yield bonds are at the most attractive valuations for several years, with B and BB-rated securities being singled out for value-seeking investors.

Fraser Lundie, senior portfolio manager at Hermes Credit, has issued a note telling investors that more than half of BB-rated bonds issued in the past 12 months are trading below face value, presenting an opportunity for investors.

“High-yield bonds have fallen by about four points since the US Federal Reserve’s talk of tapering its stimulus program spooked investors. The shake-out, which saw valuations decline from an all-time peak in May, impacted recently issued BB-rated bonds the most,” he wrote.

“Investing blow par reduces risk of capital loss, positions investors for future prices gains, and provides put options to benefit from buyouts as more companies—particularly those in the US—consider merger and acquisition activity as they gain confidence.”

Using this derivatives strategy, Hermes has been able to exploit returns from sub-investment grade securities while maintaining the ability to redeem the bonds at more than face value, should the need arise.

Crown Holdings, a metal-packaging company, had been the subject of takeover rumours at the time of Hermes Credit’s purchase, so it acquired a change-of-control put that, if exercised, would value the bonds at nine points above the purchase price of 92 cents.

“Exploiting optionality is one of the relative-value techniques that we’ve applied for more than three years,” Lundie wrote. “As high-yield bond valuations remain generally high and liquidity at its lowest level in a decade, we seek to manage these risks and outperform by investing globally among bonds and derivatives through the capital structures of issuers.”

Hermes Credit isn’t the only fund manager enamoured with sub-investment grade bonds. Fixed income boutique 24 Asset Management is keen too.

Gary Kirk, partner and portfolio manager at the firm, told aiCIO he agreed there was selective value in sub-investment grade credit, particularly in those credits with a high single-B or BB-ratings that endured price declines in the aftermath of the Fed’s initial mention of asset purchase tapering.

“For those bonds trading at a discount to par, the upside optionality of future M&A is particularly interesting; as are those bonds which carry imbedded call prices, as these are invariably set at a premium to par,” he continued.

“There has been reasonable price correction since the Fed ‘stalled’ the tapering talk back in September and generally the initial price decline in European high yield was less pronounced than for their US dollar peers; but for selective credits in this sector we agree that there does still remain attractive upside.”

The attraction is being felt in the US too: Payden & Rygel’s head of high yield Sabur Moini said his firm had long been a believer in the value of higher-quality high-yield bonds.

“BB-rated companies are by definition less levered than single B- and CCC-rated companies and thus default risk is far more remote for such issuers as they have superior risk profiles in terms of margins and cash flows,” he told aiCIO.

“On a volatility risk-adjusted basis, the returns for the higher-quality end of the high-yield bond market are superior to that of the higher beta, lower-rated end of the asset over a five- and 10-year period.

The rush for yield in 2013 has created opportunities in the BB-rate market, and BB-rated bonds have materially out=performed in October 2013, Moini noted.

However, investors shouldn’t be fooled by 2013’s recent run of high returns of junk bonds further along the high-yield curve, he warned.

While in 2013 to date, the lower-quality end of the market had outperformed the higher-quality end, Moini believed this market had become “too toppy, or frothy” to consider now.

Related Content: Worth the Risk? Pensions Opt for High Yield Debt and Was It Worth Taking a Bet on Junk Bonds in 2012?