It’s often said that valuations in high yield bonds are expensive. Yes, this is true to a certain extent. High quality, defensive companies that are BB-rated (the ‘highest of the high’ in high yield) are indeed trading with very tight spreads. This is partly due to yield-starved investment-grade investors dipping down into high yield, pushing valuations up. It is also partly due to some investors feeling nervous about the global outlook, and therefore seeking solace in higher-rated companies. However, for B-rated companies (the middle rung of the high yield universe) credit spreads are more reasonable versus history.
Of course, by definition B-rated companies have a greater degree of credit risk. But right now it could be argued that BB-rated companies have a greater degree of valuation risk. In European high yield, Barclays have shown that 72% of BB-rated bonds are trading at a price above their next call price. This implies that the prices of these bonds cannot rise much further, if at all. High yield is sometimes described as an asset class that can exhibit ‘negatively convex’ behaviour due to the high degree of callable bonds in the universe. A callable bond that rises too far above its call price will eventually reach the point where the yield turns negative, should the bond be called. Few are willing to purchase a high yield bond with a negative implied yield, and as such, the price of that bond reaches a ceiling of sorts. Therefore, thinking in valuation risk terms, at these valuations BB-rated bonds have a very asymmetric risk profile.
Therein lies the opportunity for active managers. For example, in the US, the percentage of B-rated companies trading below par value is 23.5%; compare this to 7.6% for BB-rated companies. There is still significant capital upside for active managers that are able to invest in the credit improvement stories. However, the credit risk inherent in B-rated companies means that these bonds show a much greater degree of dispersion. As such, selecting the right ‘Bs’ is important. As always, careful, high-quality credit research is essential to avoid dispersion to the downside. But we also wield this bottom-up focused approach to capture the upside in B’s. This approach augments the already attractive carry that an investor earns by allocating to the high yield asset class.
An investment process that focuses on high-conviction stock selection can take advantage of the higher degree of dispersion in Bs. And indeed, given the valuation risk in BB-rated companies when compared with the valuation opportunity in B-rated companies, we are currently tilting our portfolio in favour of the Bs and avoiding the potential sting from complacency over the valuations in BBs. The chart below displays the unusually high degree of dispersion in single-B rated bonds; and the unusually high opportunity set for active managers to capture this.