- Interest rates are expected to continue to rise, with as many as two more expected in 2017.
- As bond markets spreads tighten, the crossover market can offer opportunity.
- A “crossover credit” strategy is designed to provide exposure to both investment grade and non-investment grade fixed income securities.
- By focusing on “fallen angels” and “rising stars”, the strategy looks to provide total return through a combination of high current income and capital appreciation.
In most credit cycles, the market hits a point when credit rating downgrades far exceed upgrades.
This ratings migration process can significantly impact the valuations of securities, particularly when credits are downgraded from a rating of investment grade to high yield. Companies that go through such a downgrade often are referred to as "fallen angels." The price dislocation that occurs as companies and sectors transition from investment grade to high yield can present significant opportunity for experienced investors in what is termed a "crossover market."
Crossover market opportunity
There are several reasons the crossover market and fallen angels have offered investors willing to accept the additional risks the potential for excess returns. But the forced selling that often results from these credit downgrades is the primary driver.
With fallen angels, many investment managers who focus on investment grade securities have mandates with limits based on credit ratings. In general, the higher the credit rating, the larger the position size can be in a specific credit. When a credit gets downgraded to high yield, a manager invested in that security often must reduce the position to get within the mandate’s limits — and that means forced selling.
In addition, the investment grade market is approximately five times larger than the high yield market. Forced selling thus often occurs into the much smaller market and the resulting price often adjusts lower as the ratings transition happens. Fallen angels also tend to be much larger companies with more debt outstanding when compared to companies rated high yield, which adds to the transition challenges from a larger to a smaller market. In general, the more downgrades that occur over a short period of time, the more attractive the potential opportunities become on a risk-reward basis.
Market factors at work now
In latter 2015 and early 2016, commodity-based sectors (particularly energy and metals) experienced significant pressure downward in both the equity and debt markets. As a result, many commodity-based companies were downgraded in 1Q2016. This resulted in the majority of the energy and metals sectors in both investment-grade and high yield markets experiencing extreme price volatility. This downward pressure on bond prices was exaggerated by the forced selling that occurred, as many former investment-grade companies were downgraded to high yield (fallen angels).
To illustrate the price volatility that occurred during this time, the average price of high yield bonds in the energy sector according to Bloomberg Barclay indexes for the investment-grade and high yield categories was $60 at the end of February 2016. The investment-grade market experienced similar pain with average price on bonds in the energy sector at $91 per the Bloomberg Barclays indexes. One year late at February 2017 month-end, the same average prices were at $99 and $106 in the Bloomberg Barclays High Yield and Bloomberg Barclays Investment Grade indexes, respectively. It is important to note that these prices were average prices for the indexes; many individual names in the cross-over market experienced more severe pricing action. Total return for the high yield energy sector was 80% and investment grade was 29% over the past 12 months ending February 2017.
Attractive risk-reward opportunities similar to what occurred in the crossover energy sector over the past year present themselves in various sectors and individual names over the course of credit cycles. In times when risk-reward opportunities are limited, it is generally a prudent strategy to invest in the higher credit quality (BBB rated credits) parts of the crossover market. In other times, as was the case in early 2016, it definitely paid to be more aggressive.
Historical returns offer a guide
Although the crossover market is not widely discussed as a distinct market, it has been recognized with its own returns and statistics for more than 20 years. The total return history of the crossover market compares favorably to both higher- and lower-quality credit during that time.
For example, the annualized return for the crossover market was 6.14% in 2011-2016, compared with 6.96% for high yield and 4.59% for investment grade.1 In 2009, the last time crossover downgrades were material relative to upgrades, the annualized return was 48.05%.2 Although it may be unrealistic to expect a repeat of 2009’s total return, we think the magnitude of expected downgrades in 2017 is comparable. On a risk-adjusted return basis for the period 2011-2016 using the Sharpe Ratio, the crossover result of 2.05 was slightly less than high yield at 2.66, but exceeded investment grade at 0.63.3
Low correlation with interest rate moves
One way to examine the relationship between securities or among factors is through “correlation” — a statistical measure of how two securities move in relation to each other. A correlation of +1 indicates the securities moved in lockstep through a specific time period.
Securities in the crossover market historically have not been highly correlated to interest rate changes, as typically has been the case with investment grade credit. In fact, the correlation between U.S. Treasuries and crossovers is only 0.13 since 1984, compared with 0.79 for investment grade.
Based on this historical relationship, we believe crossovers are not likely to be materially affected as interest rates rise. In each of the eight years since the onset of the global financial crisis, crossovers have not had a single year in which they underperformed both investment grade and high yield, based on returns in the Bloomberg Barclays indexes.
Pursuing the potential now
In our view, investments in the crossover market offer the potential for higher risk-adjusted returns versus the high yield market, without the high correlation to interest rate changes of investment grade credit. That’s an important consideration in the current environment, since the U.S. Federal Reserve has begun moves taking interest rates higher.
History also shows that the crossover market has been most attractive at the end of a credit cycle, when rating dislocations were at their peak. For these reasons, we think 2017-2018 offers a potential opportunity in the crossover credit market.
1Source: Bloomberg Barclays. Cross-over returns based on BofA Merrill Lynch U.S. Diversified Crossover Corporate Index, which represents U.S. dollar-denominated BBB and BB corporate debt publicly issued in the US domestic market; high yield based on the Bloomberg Barclays U.S. High Yield Corporate Index, which represents the U.S. dollar-denominated, high-yield, fixed-rate corporate bond market; investment grade based on the Bloomberg Barclays U.S. Credit Index, which represents the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate and government-related bond markets. It is not possible to invest directly in an index.
2Source: Bloomberg Barclays. Cross-over returns based on the BofA Merrill Lynch U.S. Diversified Crossover Corporate Index, which represents U.S. dollar-denominated BBB and BB corporate debt publicly issued in the US domestic market.
3The Sharpe Ratio is a measure of risk-adjusted returns used to characterize how well the return of an asset compensates the investor for the risk taken. A positive Sharpe Ratio in a fund means the returns have compensated investors for the risk they have taken.
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Past performance is not a guarantee of future results. The opinions expressed are those of the Ivy Funds and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through April 2017, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.
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