If we consider that government bonds usually offer little protection in a context of rising yields, it is often natural to turn attention to high-yield bonds with a rating lower than C in order to seek returns, thus losing sight of the quality of one's portfolio.
In addition to this factor, high yields are a very heterogeneous category and like other bonds suffer from the same biases as cap indices. The investment universe is quite limited and in Europe the capitalization is only 273 billion euros compared to 1.503 billion for investment grade bonds. And finally, despite a respectable average annualized return, these bonds are very volatile and can suffer significant drawbacks.
Crossover area
The distinction between investment grade (BBB- and up) and high yield (BB+ and down) is owed to the rating agencies and is widely accepted as the dividing line in fixed income. And many managers, due to portfolio constraints, as well as not being able to cross the border, also have to stay away from it. In this way, opportunities are created for investors with greater flexibility and who can focus on the area between the two categories.
We define this niche with the term crossover or with the acronym 5B (ie BBB and BB) and it is an investment universe with interesting risk / return characteristics. The average annual return between 2007 and 2013 was +6,81%, higher than investment grade securities (+4,73%) and lower than high yield. However, in an overall assessment it is necessary to consider two further elements: volatility, equal to 6,4%, slightly higher than investment grade (4,5%), but decidedly lower than high yield (14,7%); and the maximum loss, which for the 5B universe was -9,9%, while high yields recorded -39%.
In light of these factors, it is evident that the risk/reward ratio is favorable to the crossover segment compared to the other two categories.
fallen angels
Issuers that go from investment grade to high yield due to a downgrade are known as fallen angels. The most recent examples are Telecom Italia or Lafarge. In such cases, due to constraints on the mandate, many managers are forced to close positions, often at a loss. After moving into the high-yield category, the bond becomes attractive again for investors specialized in this segment and the price rises following the purchases.
Some research on the US market has shown that the returns of an issuer that undergoes a downgrade are negative for the three quarters preceding the news, as well as in the month of the downgrade. And this translates into an average underperformance of 15,09%. Returns remain slightly negative for the following quarter, but the price then reverses and over the next 24 months these issuers outperform their peers by an average of 6,63%.
These numbers highlight the opportunities offered by this segment. We currently see significant interest in hybrid corporate bonds and subordinated bonds in the banking sector. On these latest issues, one of the most interesting characteristics is due to the fact that they are often new structures with very simple pricing. Of course, it helps a lot that the financial industry is going through a deleveraging phase, which is always a good thing for those looking to invest in bonds.
