Higher yields have so far left the credit market largely unscathed, but they have changed the balance of opportunity.

As we have already noted, one remarkable aspect of the recent sell-off in Treasuries is that it affected equity markets much more than credit. The credit spread of the ICE Bank of America U.S. High Yield Index is actually around 30 basis points tighter than at the start of the year, resulting in an almost flat total return.

The calm at the total index level disguises interesting developments under the surface, however, which are related to the jump in yields. As the momentum in Treasuries takes a pause, it’s worth taking stock of how these undercurrents have changed the credit opportunity set.

Fundamentals

Six months ago, we wrote about shifting the balance in some portfolios away from the “fallen angels” that had recently been downgraded from investment grade and had led last summer’s recovery in high yield. Instead, we were focusing on select CCCs, which had lagged the higher-rated sectors even though we thought some of them had the quality of single B credits.

Since then, the ICE Bank of America CCC Index is up by 19% and the BB Index by 6%.

We believe that reflects the remarkably healthy fundamentals that high yield has exhibited since the U.S. Federal Reserve stepped in to keep the market open last year, enabling many businesses to refinance and survive the worst of the coronavirus crisis.

The proportion of the high yield bond market now trading below 50 cents on the dollar is just 0.4%, below even the pre-pandemic low of 0.9%. Only 2.7% of high yield bonds trade with a spread of more than 1,000 basis points, the lowest proportion since July 2007. We see the same picture in loans.

After hitting $130 billion in 2020, the value of bonds and loans defaulting so far this year is only around $2 billion. In leveraged loans, the 3.8% default rate for 2020 was less than half that of 2009. Our latest forecast for 2021 is that loan defaults will top out at 1.89%, similar to the average of the pre-pandemic decade.

Stable Spreads, Higher Yields

If our preference for CCCs last summer was partly about relative value and partly about our analysis of market fundamentals, it was also partly about our investment theme of seeking income without too much interest rate sensitivity. The outperformance of CCCs owes something to the fact that their average duration is just 2.4 years, as opposed to 4.4 years for the average BB.

While the Treasuries sell-off may have left the credit spreads and total return of the High Yield Index largely unscathed, as my colleague Chris Kocinski has pointed out, it has led to a pick-up in yields. That makes it interesting to look again at the higher-rated sectors that are more sensitive to rates—particularly, in our view, those fallen angels we liked so much last summer.

From Fallen Angels to Rising Stars

As we move from recession to early-cycle recovery, those fallen angels, as well as other improving credits that have never been rated above BB, are now much more likely to become “rising stars”—bonds that get upgraded from high yield to investment grade, often receiving a welcome valuation boost as big index funds make their purchases.

In high yield bonds, rating downgrades outnumbered upgrades in every month of 2020. The balance tipped in January of this year, and in February three times as many bonds were upgraded than downgraded. In the BBB and BB rating bands, the first quarter of this year has seen more than $10 billion worth of rising stars and zero fallen angels, the first time that has happened since the summer of 2017.

The ICE Bank of America Fallen Angel Index has a duration of 6.5 years. These used to be high-grade companies, which are generally able to issue bonds with longer maturities. In our view, as a consequence of that, the Treasuries sell-off has left many of them trading at yields out of all proportion to their relative size, liquidity, high quality and potential for rating upgrades. The Fallen Angel Index currently yields just under 4%, which is 40 basis points more than the BB Index and only 40 basis points less than the total High Yield Index.

Against this year’s early-cycle background, we anticipate further tailwinds for the lower-rated, more economically sensitive part of the credit market. Right now, however, perhaps with some of their duration hedged out, we believe these more interest rate-sensitive potential rising stars present the most attractive risk-adjusted valuations.

Brad Tank, Chief Investment Officer—Fixed Income
March 29, 2021