DEC
12
2016
Higher Quality Junk Bonds for 2017 and Beyond???
Regina Borromeo »
Instead of "Trumpageddon" we have seen "Trumpflation"—the prospect of U.S. inflation that may occur because of
Trump’s presidency—move across equities and other risk assets. Since the election, the biggest losers have been gold
and many rate-sensitive sectors across fixed income. In an environment of rate volatility and geopolitical risks, we
believe there is a solution for yield-starved investors without having to take on too much default and illiquidity risks. In
our opinion, higher-quality high yield credit—meaning corporate bonds rated BB/B—can provide attractive total return
and income. Improving fundamentals driven by a wave of refinancing since the Global Financial Crisis (GFC) and more
sound operating performance have dramatically improved credit risks among these issuers. Risk and return
characteristics of high yield can vary significantly by region, ratings, duration, sector, and liquidity. Furthermore, high
yield "fallen angels"—bonds that were investment grade at the time of issuance but have since been downgraded to
below investment grade—globally have significantly outperformed original issue high yield and are an attractive
component of the better-quality high yield universe. Some household names such as Apple were fallen angels in late
1990s while recent fallen angels include the likes of Anglo-American and Dell. Fallen angels are a growing segment of
the global high yield universe, increasing from about 8% of the market in 1999 to 22% today.
In our opinion, investing in the BB/B segment along with fallen angels is an attractive way to earn income and total
return with less volatility. We believe these segments of the global high yield market provide equity-like returns with
limited default risk. First, fallen angels generally have a higher credit quality than original issue high yield, along with
generally not being callable and a different sector composition than original issue high yield. We attribute the strong
total return performance of fallen angels due to forced selling and overreaction by investment grade investors, more
attractive call features—fallen angels tend not to be callable—which can offer better returns when spreads rally.
Furthermore, these issuers tend to have the ability to access the capital markets as a way to shore up their liquidity
situation and management teams are usually incentivized to regain investment grade status. Due to fallen angels and
the increase in small- and medium-sized enterprises (SMEs) accessing the debt capital markets across Europe and
developed markets following the GFC, the global B/BB segment has outgrown the U.S. high yield market during the past
decade. As shown in Chart 1 below, the Bank of America Merrill Lynch Global High Yield B-BB Index is over $1.8
trillion in market value compared to the Bank of America Merrill Lynch U.S. High Yield Index at $1.3 trillion.
Investors can participate in the upside without bearing too much default risk. Furthermore, the weighted average
quality of global high yield BB/B segment has continued to improve over the past decade, from B+ in 2006 to BBtoday. There are a lot of events within the BB space that can lead to a material tightening of credit spreads, which can
serve as a catalyst to becoming rising stars into investment grade. Once an issue gets upgraded to investment grade,
material spread compression occurs, resulting in capital appreciation and providing the opportunity to capture total
return. In addition, this segment experiences less duration sensitivity than BBB and investment grade credit; in an
environment of increasing rate volatility, the incremental spread/yield provides some cushion. We believe selecting
higher-quality junk bonds alleviates concerns of assuming undue default risk and going down to less liquid securities.
As shown below in Chart 2 below, BB/B-rated credit makes up the bulk of the trading volume since the GFC.
High yield is not a homogenous asset class, since there are nuances that can dramatically alter risk/return profiles. We
believe it is important to understand how these differences can alter risk and return in the long term. According to the
ratings agency Standard & Poor’s, 65% of issues rated CCC to C have historically defaulted within five years, compared
to 3.4% for BB-rated bonds. Investing in better-quality high yield can provide higher risk-adjusted returns and better
downside protection compared to investing to CCCs. For investors searching for incremental yield with less price
volatility associated with the equity market and the lowest quality segments of the high-yield market—bonds rated
below single B—the BB/B segment of the global high yield credit market may offer an attractive risk-adjusted return
opportunity.
Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to
ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no
different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of
our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although
individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.
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