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Institutional Perspectives

Elevated prices for ‘BB’-rated securities in both the high yield bond and leveraged loan markets suggest better value and upside in certain lower-rated credit.

 

In Brief

  • Despite a segment-wide rally during December, the full-year performance of U.S. lower-quality credit in 2019 was anomalous with ‘BB’-rated securities outperforming in an otherwise favorable market environment.
  • Analyzing data starting from 2012, we found that BB bonds underperformed the broader high yield category 75% of the time over the ensuing 12-month period, with a median underperformance of 1.88% when BBs were at a level of call constraint similar to or greater than today.
  • Similarly, in the leveraged loan market, when BB bonds exceeded the current BB index price, they underperformed 81% of the time over the ensuing 12-month period, and the median underperformance over all these periods was 0.86%.

 

As we move into 2020, investors are looking beyond 2019’s solid performance across much of the leveraged finance markets to consider the potential investment themes that may play out over the next 12 months.  While we typically don’t find much value in simply recapping prior performance, it is notable that despite an outsized rally in ‘CCC’-rated securities in December, ‘BB’-rated issues still strongly outperformed CCCs across both the high yield bond and leveraged loan markets for the full year. That outcome was consistent with other asset classes as well, with the bid for safety overshadowing lower quality, higher beta segments within many asset markets for most of 2019.  

However, in our opinion, the safety bid may be reaching a dead end. We have seen some thawing in U.S.-China trade tensions and related prospects for continued macro improvement, especially in light of some initial “green shoots” in recovering manufacturing and corporate confidence. Some investors may see these developments pushing off the end of the economic and credit cycles beyond 2020.

Constrained Upside in BBs?
But what’s the setup for the high yield and leveraged loan markets now, as segmented by credit quality? In Chart 1, we track through time the par-weighted percentage of ‘BB’- and ‘B’-rated bonds, and the overall high yield market, that are trading at or near their next call price (“call constrained’). With 2019’s BB outperformance behind us and an index of BB corporate bonds today at an average price of $104.9, over 80% of the par value of BBs is call constrained, compared to just 60% in the ‘B’-rated category. Further, note that BBs were similarly constrained at times during 2013 and 2014, but Bs today are not yet at the same levels of upside constraint as they were in during that period.

Why are these comparisons important? They show that these above-par BBs face significantly asymmetric risks: price upside is limited because yield declines may result in a call of these securities by issuers, while yield increases may result in significant price declines from interest rate sensitivity and term extending from the next call date to maturity date.

Similarly, on the right side of Chart 1, we track the weighted average dollar price across ratings cohorts in the leveraged loan market. Recall that loans are typically callable by the issuer after the first six months after issuance (typically at $101), so the call constrained characterization of the high yield bond market isn’t exactly transferable to an analysis of the loan market. Nonetheless, on a relative value basis, we find that the overall leveraged loan index today is around $96.64 compared to $101.4 for the broader high yield bond market. We believe that alone is a modest relative value argument in favor of loans, simply based on price terms.

But perhaps more importantly, as with bonds,’ BB’-rated loans look more upside constrained in price terms relative to Bs. Indeed, a quick glance at the chart shows that a similar price gap that existed in late 2016 closed thereafter with BB loans trading sideways (i.e., near par), while the rest of the loan market moved higher in price terms.  And we are seeing some of the negative implications of elevated prices in BB loans already with the recent pickup of repricings in BB loans. The astute reader will note that we haven’t tracked the index price for ‘CCC’-rated loans (currently at $80.80), but at just 6.2% of the market value outstanding, the omission of the lowest speculative-grade tier likely won’t influence most investors’ assessment of the loan market, in our view.

 

Chart 1. Upside for ‘BB’-Rated Securities Appears Limited in Both the High Yield Bond and Leveraged Loan Markets
Percentage of bonds (left panel) trading at or near next call price, and loan index prices (right panel), by indicated category, December 31, 2011–December 31, 2019

Source: Bloomberg. HY Index=Bloomberg Barclays U.S. High Yield Index. LL Index=Credit Suisse Leveraged Loan Index. Data as of December 31, 2019.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.
 

What Past Price Trends May Suggest for ‘BB’-Rated Bonds
Next, we look to history as we consider how the various ratings cohorts across leveraged finance could potentially perform over the coming year given the current state of elevated BB prices relative to Bs and the rest of the bond and loan markets.  In Chart 2, we focus first on the high yield bond market (left panel).  Using monthly data from 2012 (appreciably long after the market distortions around the 2008-09 recession, and ensuing price recovery), we plot the percentage of BBs characterized as call constrained at each month versus the ensuing 12-month total return difference versus the broader high yield market.  

  • In months where less than 80% of the par value of BBs is call constrained, BBs underperformed the broader high yield market just over half the time (34 out of 65 observed 12-month rolling periods) with a median of 0.19% of underperformance; essentially, a coin-toss.
  • But on the flip side, when BBs were more than 80% call constrained (a touch lower than the the 86% today), BBs underperformed broader high yield more frequently and with greater intensity: 75% of the time (15 out of 20 observed 12-month rolling periods) with a median of 1.88% of underperformance over all these periods.

 

Chart 2.  History Suggests Higher-Priced ‘BB’-Rated Bonds and Loans May Be Poised to Underperform
Data for the period December 31, 2011–December 31, 2019

Source: Bloomberg. HY Index=Bloomberg Barclays U.S. High Yield Index. LL Index=Credit Suisse Leveraged Loan Index. Data as of December 31, 2019. The chart on the left depicts the 65 observed ensuing 12-month rolling periods during the December 31, 2011–December 31, 2019 timeframe in which less than 80% of the par value of ‘BB’-rated bonds was call constrained (trading at or near their next call price)  and the 20 periods when more than 80% of BBs were call constrained, and the performance of these periods in comparison to the ensuing 12-month total return difference versus the broader high yield market, as represented by the Bloomberg Barclays U.S. High Yield index. The chart on the right depicts the 43 observed ensuing 12-month periods during the December 31, 2011–December 31, 2019 timeframe when the average price for ‘BB’-rated loans was below the level of $99.81 at December 31, 2019, and the 42 periods exceeding the $99.81 level, and the performance of these periods in comparison to the broader loan market, as represented by the Credit Suisse Leveraged Loan Index.

The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

 

Next to a similar analysis of the loan market, we find:

  • In months where the BB loan price index was below the current level of $99.81, BBs underperformed just over half the time (24 out of 43 observed 12-month rolling periods), and BBs trailed the broader loan market by a median of 55 basis points (bps) over these periods.
  • But when BBs exceeded the current BB price index, they underperformed 81% of the time (34 out of 42 observed 12-month rolling periods) and the median underperformance over all these periods was 0.95%.

While there are a number of performance statistics above, and other ways we could segment the data more finely, our takeaway here simply is that given high dollar prices for BBs in both the high yield bond and leveraged loan markets, we believe that prospects for BB-heavy strategies look poor from here. Certainly there are other market environments, such as when an economic downturn seems more imminent, where an up-in-quality constrained bias may be warranted. But we don’t believe such fears should be the base case, even though they appear to be reflected in the price of bonds and loans today.

Summing Up
We have long emphasized that one of the differentiated strengths of our leveraged credit platform is our inherently unconstrained approach to portfolio construction that allows us to migrate up and down in credit quality as the spread opportunity and macro environment warrant. As credit rallied through 2019, we decreased our BB exposures in both high yield and leveraged loans, finding better value in other segments of the credit markets. We maintain that preference away from BBs going into 2020, a stance we believe will benefit performance should our view on the extension of the credit and economic cycles be proven correct.

 

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