Risk Becomes a Safe Haven in Volatile Debt Market
(Bloomberg) -- In today’s topsy-turvy credit world, risky bonds are outperforming safe ones in periods of volatility. The reason? An increasing focus on interest income, or carry in industry parlance.
Strong inflows into credit funds have compressed spreads — the premium for buying corporate debt rather than safer government bonds — so much that further tightening looks unlikely. That’s left money managers seeking other ways to beat their benchmarks. Low-rated and junior bonds are increasingly attractive to them because the higher coupons they typically pay help offset falling values when yields move up.
The trend is so powerful that high-yield securities dropped less than their blue-chip counterparts during the worst of the bond selloff earlier this month, even though the companies that issue them are more likely to go bust. A similar story is playing out with subordinated securities, which have performed strongly under a measure that compares investment returns with risk known as the Sharpe ratio.
“This is reinforcing the view that carry is the flavor of this year. The lowest-risk assets” — sovereign bonds — “have been the most volatile and you have recently got the best Sharpe ratios in things like CoCos,” said Ninety One portfolio manager Darpan Harar. CoCos, an abbreviation of contingent convertibles, are a type of subordinated note issued by banks.
Risky bonds are usually what investors call high-beta instruments: they gain more when times are good but lose more in bear markets. What’s different this time is that fiscal deficit concerns are making government bonds less attractive, while differing interest rate cut paths make riding an expected decline in yields as policy rates fall an uncertain strategy.
“People are starting to realize that credit spreads are not the volatile part now, the volatile part is the risk-free rate. It’s completely turned upside down,” said Flavio Fabbrizi, head of corporate debt capital markets for Europe at HSBC Holdings Plc.
Shorter Duration
Another factor is that high-yield bonds are typically shorter duration than high-grade notes, making prices less sensitive to yield changes. A Bloomberg-compiled global junk bond gauge has almost half the duration of its investment-grade counterpart, meaning that a one-percentage-point increase in yields will trigger double the price drop in safer bonds.
Even though junk bonds were caught in the recent selloff, triggered by concerns that the US Federal Reserve especially would have little reason to cut interest rates, the biggest year-to-date loss for the sector through Thursday was 0.57%, Bloomberg-compiled data shows. For high-grade bonds, it was about three times that and — unlike junk bonds’ strong rebound — they have barely managed to break even for the year.
Similarly, senior bonds issued mostly by European banks generally lagged Additional Tier 1 bonds, the riskiest type of bank debt, and remain in the red.
Still, questions about refinancing costs are also bound to emerge as many notes that are coming due feature relatively low risk premiums.
“You do have to be careful to avoid those bonds which may have refinancing issues because the spreads are not very high,” said Per Wehrmann, a high-yield portfolio manager at DWS Group. “Otherwise it can become like picking pennies up in front of a speeding train.”
Assuming the borrower doesn’t default, investors can expect to earn at least the coupon payment, making it particularly important when yield or spread movements are loss-making.
“Your first line of defense as credit manager is carry,” Harar at Ninety One said.
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--With assistance from Ronan Martin, Taryana Odayar and Dan Wilchins.
