Bond investment decisions are supposed to be made on a Investment-grade versus Non-investment/ High yield bond binary. Right?

Not quite!

We explain why.

As we delved deeper into this and did more granular analysis, we discovered that all rating categories within High Yield bonds are not created equal.

This is what we found: Higher-quality high-yield bonds are likely better bets for long-term investors than those that are rated lower or even ETFs that track the broad high-yield market.

In fact, in risk-adjusted terms, the highest rated High-yield bonds (Ba or BB rated) provided better returns than both the investment grade bonds as well as the lower rated junk bonds.

Let's now dive deep into this! 

It's easy to get into trouble in the junk-bond market, where credit quality and liquidity can deteriorate quickly.

 But the interesting finding is that higher-quality high-yield bonds are likely better bets for long-term investors than exchange-traded funds that track the broad high-yield market, and not just because they carry less risk. These bonds are more likely to be undervalued than their lower-rated counterparts. 

This is due to mispricing that can arise from two inefficiencies in this market: yield-chasing and forced selling. Here's a closer look at why these inefficiencies exist and how to profit from them.

Credit Risk Doesn't Always Pay

Over the long term, there should be a positive relationship between credit risk and returns. Investors expect to be compensated for bearing credit risk. Otherwise, no one would take it. Understanding this, lower-rated bond issuers tend to offer higher yields to attract investors.

As shown in Exhibit 1, there was a positive relationship between credit risk and returns from the highest-rated corporate bonds (AAA) through the highest-quality level of junk bond (Ba), from July 1983 through January 2020. Each step down the credit rating ladder came with a comparable or slightly better return. This is the relationship between risk and reward that would normally be expected

However, within the confines of the junk-bond market, this relationship gets turned topsy-turvy. Here, returns declined with each step down the credit rating ladder. The underperformance of the lowest-rated debt is persistent, as shown in Exhibit 2.

The Sharpe Ratio (i.e risk adjusted returns) for Baa and Ba rated bonds is significantly higher than that for both investment-grade bonds and lower rated junk bonds.

This is hard to reconcile with classic financial theory, which assumes risk and expected returns should always move together.  Next, instead of just looking at point-in-time numbers, we also considered the total return and reward/risk ratio for the above mentioned bond indices on a 5-year rolling basis (see charts below) to generate a more accurate assessment.

Source: Bloomberg, author's calculations. Data as of 13th July, 2020.

From Figure 1, it can observed that on a 5-year rolling total return basis, the highest quality junk bonds i.e. BB/Ba rated bonds (red) have outperformed all other lower rated junk bond categories except during post-crisis rebounds when the beaten down categories like CCCs or Caa rated bonds have provided a higher annualized total return. 

  Our analysis shows that BB or Ba rated bonds have historically outperformed the broader US high yield market almost 70% of the time on the 5-year rolling total return metric!   However, rolling returns display only one side of the coin. A rational investor would ideally look at the reward (i.e. return) relative to risk (i.e. volatility).  Figure 2 highlights the fact that BB or Ba rated non-investment grade bonds (red) have consistently provided the highest reward/risk ratio on a 5-year rolling basis compared to all other lower rated junk bonds and even higher than BBB rated investment grade bonds!

Our analysis shows that BB or Ba rated bonds have historically outperformed the broader US high yield market 96% of the time on the 5-year rolling reward/risk ratio metric!

This surprising relationship isn't the result of inaccurate credit ratings. This is borne out by the fact that lower-rated bonds had progressively higher default rates and credit losses than higher-rated bonds (1).

It's possible that investors understood the lowest-rated bonds' credit risk and thought they were getting sufficient compensation, but they just had a long string of back luck where realized credit losses exceeded their expectations. However, aggressive yield-chasing is the more likely culprit.

Lower-rated bonds tend to offer higher yields than those with higher ratings. This may be because they are trading at a deep discount to par value, offer a high coupon rate, or some combination of the two. 

This can make them attractive to income-oriented investors, who prioritize current income over capital gains (and therefore the possibility of capital losses), sometimes to the detriment of total returns.

Even professional money managers aren't immune to overpaying for bonds with shaky fundamentals. 

Lower-quality bonds theoretically offer greater upside potential than their higher-quality counterparts, which could make them appealing to active managers who are trying to beat their benchmarks. However, their collective bets on those securities could push their prices above fair value, leading to disappointing long-term performance (2). Managers may also be overconfident in their ability to identify low-quality issuers with improving fundamentals and discount the risks.

A Sweet Spot
While Ba rated corporate bonds aren't enticing enough for many high-yield bond investors, they are deemed too risky for many investment-grade investors. This has not only allowed them to deliver not just higher returns than all other rated corporate bonds, but also better risk-adjusted performance.

It's not realistic to expect Ba bonds to post better returns than the broad high-yield bond market indefinitely. As more investors become aware of the meager compensation the lowest-rated junk bonds have historically offered, they are likely to tilt away from those bonds, which should help create a more rational relationship between risk and return. 

However, as long as many continue to prioritize yield or upside potential over risk-adjusted performance, Ba bonds will likely continue to offer better risk-adjusted performance than the rest of the high-yield bond market.

By the way, you can also WhatsApp us on +91 8850169753 

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