You’ve probably heard about top down and bottom up assessments of markets. Here Sebastian Ashton, a Sydney based director with over 20 years international and domestic experience searched the global high yield bond market to identify attractive investment opportunities.
Most investors share the view that absolute valuations in credit, which is corporate bonds, are stretched as we continue to emerge from an unprecedented period of low interest rates and quantitative easing in many developed markets.
Strategies that exploit idiosyncratic opportunities and relative value are now the key drivers of returns. In a market that is generally overvalued, pockets of value and opportunities to generate ‘alpha’ can be found by focusing on the segments of the market that exhibit the most dispersion and hence provide a larger opportunity set for investors to focus on.
Discussion and analysis
Given very low yields on offer many investors continue to look for opportunities to invest in sub-investment grade credit that pays higher returns. The ‘beta’ trade in credit that ended a couple of years ago when central banks began talking about policy normalisation had previously been a key driver of returns post the global financial crisis.
In terms of global high yield opportunities the US market presents the largest and most liquid opportunity set, see Figure 1.
Developed world high yield bond markets relative size ranked by median credit spread
Source: Bloomberg Barclays US Corporate High Yield Index (LF98TRUU) & Bloomberg Barclays European High Yield Index (LF01TREU)
Figure 1
Within the US market, although valuations are tight, the breadth of diversity given the market size still offers attractive investment opportunities for those who are nimble and selective.
We visualise spread dispersion in the US high yield market with Boxplots, at each credit rating level using Bloomberg’s composite ratings see Figure 2, and conclude the following:
In the US market, FIIG limits investment to a minimum B-.
Accordingly, our analysis suggests the single B rated bucket within the US high yield market is the ‘sweet spot’ where investors should focus their attention when searching for idiosyncratic investment opportunities.
Unsurprisingly, CCC rated companies have the widest spread dispersion given the stressed / distressed nature of this segment of the market. However, the very high risk profile does not suit many investors.
Credit spread dispersion in the US high yield market
Source: Bloomberg Barclays US Corporate High Yield Index (LF98TRUU)
Figure 2
Figure 3 shows the US high yield market price time series statistical summary for the B rated bucket over the last two years from September 2016. The chart shows that price dispersion has reduced as investors moved away from the ‘beta’ trade and into an idiosyncratic strategy that continues to play out. We also note that the median market price has declined slightly over the five periods where we conducted our study, probably due to the shift upwards in interest rates.
Single B rated bond price dispersion and median market price evolution in the US high yield market
Source: Bloomberg Barclays US Corporate High Yield Index (LF98TRUU)
Figure 3
Conclusion
Within the single B rated segment of the US high yield market where we have identified an attractive opportunity set to potentially generate alpha we recommend the following investment.
Deanfoods 6.5% Mar 23 - Bloomberg composite credit rating ‘B’
The Deanfoods 2023 US dollar bond currently trades at a discount to par and offers an attractive entry level for investors, yielding over 7.50%pa. The bond offers relative value compared to its peers of the same rating, offering ~80 basis points higher yield than Avon 2022 and Calpine 2023. It has a 2023 maturity, which we’ve been recommending clients hold shorter dated US dollar bonds on rate rise expectations from the Fed Reserve.
Glossary
Alpha
Alpha is a measure of the active return on an investment compared with a suitable market index.
Beta
Beta is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors.
Z Spread
The Zero-volatility spread (Z-spread) is the constant spread that makes the price of a security equal to the present value of its cash flows when added to the yield at each point on the spot rate Treasury curve where cash flow is received. In other words, each cash flow is discounted at the appropriate Treasury spot rate plus the Z-spread.