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High-Quality Junk Bonds: An Oxymoron or Opportunity?

October 12, 2017

Over the last several years since exiting the “Great Recession,” fixed-income investors have generally benefited from a compelling backdrop for advantageous bond market returns. Contributing factors to the continuing “bull market” in bonds include a continuing low rate of inflation, the corresponding accommodative policies of global central banks and an associated relatively low default rate.

Bond investors should be happy and satisfied with the bond market, right? Not necessarily. Bond investors seeking a specific yield target or searching for income today have undoubtedly been hampered in their endeavor. Such investors must either take on additional risk to meet the yield targets that were easily attained in previous market cycles or become resigned to the fact that they will simply fall short in meeting their investment goals. Consequently, investors have been pushed to seek higher-yielding and oftentimes more volatile investment vehicles within their fixed-income allocation, including gravitating toward the lower-rated categories of the high-yield market.

The high-yield market’s solid performance of late may have transitioned those same investors toward thinking the junk bond market had either somehow overcome its historic volatility or believing that such volatility is just a “necessary evil” associated with meeting their yield targets.

Believing the market’s relative stability was sustainable, investors may have absorbed more risk within their bond portfolios — perhaps not fully aware of the added volatility such a strategy represented.

High Yield and Less Volatility

Although difficult to predict, market volatility has the potential to disrupt returns across all high-yield rating categories due to unforeseen shifts in risk appetite and near simultaneous adjustments in valuations. Unfortunately, many investors tend to forget the lessons of the recent past and ignore those slumps, or they accept the volatility as a trade-off of investing in the high-yield sector to achieve those sought-after high returns.

But exorbitant volatility needn’t be a “necessary evil” associated with seeking higher returns in the high-yield bond market. A focus on BB credits has historically provided investors with a risk/return profile that sits in a differentiated, more stable position in comparison to other rated segments of the corporate bond market. Importantly, this ratings category displays significantly less volatility than the rest of the high-yield market.

Bank of America Merrill Lynch research indicates that, between 1993 and 2016, BB rated bonds exhibited an average monthly total rate of return of just above 0.65% with a monthly standard deviation (a statistical measure of historical volatility) of approximately 2%. While the CCC bond class posted higher returns with an average monthly total rate of return of near 0.70%, this coincided with a monthly standard deviation of approximately 4%. Simply put, in exchange for a bit more yield, investors had to accept twice the volatility.

Most would assume that, given the more limited volatility, BB rated bonds would underperform lower-rated segments of the high-yield market over time. However, between 1984 and 2016, higher-quality BB rated bonds, as tracked by the Barclays Ba Corporate Credit Index, actually outperformed all other lower-rated, high-yield segments. These BB bonds also outpaced the overall fixed-income market, as tracked by the Barclays U.S. Aggregate Bond Index.

Of course, during shorter time periods of very favorable credit environments, lower-rated or lower-quality credits would be expected to outperform the higher-rated, less-volatile BB issues within the high-yield market, as seen during 2016. Yet to take advantage of the lower-rated components of the high-yield market’s potential, investors must possess the knowledge to time their trade to take advantage of the increasing valuation and then dodge the increased underlying default risk at the turn in the cycle. What makes this more difficult is that such trading-oriented bond investors cannot rely on high-yield market makers to provide liquidity for them when it is most essential.

The BB Solution

For risk-averse yet income-seeking investors, a larger weighting of higher-rated, high-yield bonds (as represented by BB issuers) offers a competitive yield paired with more limited downside price volatility versus traditional, lower-rated high-yield investment options. More importantly, a high-quality, high-yield investment strategy lets investors reap an appealing return from a high-yield product over the long term. In a sense, bond investors can potentially capture the best of both worlds in the high-yield marketplace with BB bonds — an attractive high-yield return profile but more limited volatility during the occasional market storm.